Cash offers flexibility, but it’s time to start thinking longer term
Investors have been investing in cash or cash equivalents due to the historic underperformance of fixed income markets and higher yields than certain longer-term bonds. However, with an economic downturn expected in 2023 or 2024, we believe adding longer dated bonds to lock in high yields could be a valuable move.
Given the historic underperformance of fixed income markets last year and the fact that cash yields more than certain longer-term bonds, many investors have invested in cash or cash equivalents. With the consensus outlook of an economic downturn in later 2023 or early 2024, we believe adding longer dated bonds, and therefore locking in high yields, could prove valuable going forward. We think investors may not fully appreciate the risks of continuing to overweight short-term investments or cash nor the yield cushion bonds currently offer against further price declines. Although an allocation to cash for flexibility is prudent, we believe it’s time to start thinking longer term.
Potential price appreciation
As 2022 proved, bond prices fall as interest rates rise. The converse is also true, bond prices rise as interest rates fall. This relationship between price and interest rates is known as duration. The greater the duration, the greater the potential for price appreciation when rates decline. With short term investments such as Treasury Bills (T-Bills) and cash there is essentially no opportunity for price appreciation. If the economy slows or if the Federal Reserve lowers interest rates, investors could earn higher returns in longer dated (non-cash) assets. The price of longer maturity bonds will increase more than the price of cash or short-term investments.
If short-term interest rates fall, short-term investments or cash investors will need to reinvest at a lower rate, reducing future returns. When investors buy longer maturity bonds, they are exposed to less reinvestment risk. The market consensus on the most likely path for interest rates over the next twelve to twenty-four months is lower. While cash or a short-term investment may provide an attractive yield today, that yield, and therefore the income generated, may evaporate with little to no potential for capital appreciation as rates normalize.
When equity market volatility increases, investors often seek a lower risk investment alternative such as fixed income. This increasing demand causes the price of longer duration fixed income securities to rise. Therefore, cash or short-term investments deprive a portfolio of the equity hedge that longer-term bonds have historically provided.
Why not just buy T-Bills?
Although current yields of cash or short-term investments are attractive from a historical perspective, it is important to consider the additional returns available from other sectors, such as high-quality municipal bonds or investment grade corporate credit. As an example, over the last nine months if an investor had purchased longer maturity corporate bonds, they would have earned 4.92% more than just owning three- or six-month T-Bills.
Figure 1: The return on corporate bonds has been nearly 5% higher than the return on T-Bills
Figure 2: Cumulative returns since October-end (Index)
Source: Schroders, Bloomberg, Barclays Live, as of July 31, 2023. Bloomberg US IG Corporate Index, and Bloomberg US 3-6 Month Treasury Bill Index. Past performance is not a guide to future performance and may not be repeated.
A portfolio of intermediate or longer-dated bonds will maintain most of its attractive income-generating ability while also providing generous total returns as holdings in the portfolio appreciate during a falling yield environment. At current yields, bonds can absorb some pain if rates continue to rise without leaving investors with large losses. While cash and short-term investments still offer some value in terms of liquidity and optionality, we believe it is now time to start the process of rotating into high quality longer duration securities and locking in some of these attractive yields.