Highlights
It is now possible to extract an attractive yield from a mix of high-quality government and corporate debt instruments that are relatively lower risk, as demonstrated in the below chart. Higher yields mean investors can move up the quality scale to meet their income requirements.
Still, it can be challenging when market conditions in developed market government bonds have tested nerves this year, reverberating across other fixed income and credit asset classes. While major developed central banks have paused on rates recently, the direction is uncertain and further hikes are possible. Inflationary pressure remains elevated due to long-term trends such as deglobalisation, decarbonisation and the desire to debase existing debt burdens. Recent geopolitical tensions and disappointing earnings also add to investor anxiety.
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Take cash strategies, which invest in very short-duration papers with little interest rate risk and are yielding about 5% in US-dollar as of October 31. If interest rates continue to rise or stay in a ‘higher for longer’ scenario, cash can be an attractive option for certain income-focused investors. In addition, these strategies can serve other purposes in portfolio allocation. For example, cash may be needed as a risk buffer or to take advantage of future opportunities if investors are expecting asset prices to become undervalued in a severe economic slump.
With market uncertainty rising, some are wondering whether to rely more heavily on cash strategies? If they are tempted, what are the risks? The answer is complex and depends on specific investor targets and constraints, in addition to their views on the path of interest rates (see below chart), inflation, and economic growth.
We believe a third scenario of a recession is most likely and may start as early as 2024. In this case, central banks may pause and eventually be forced to cut base interest rates to protect growth, and cash’s outperformance over longer-duration bonds may reverse for the following reasons:
- Money market funds (MMFs) and other short-maturity, low-risk debt strategies have outperformed many longer-duration bond categories as central banks have aggressively increased interest rates since March 2022. This is largely because these strategies are more adept at closely tracking policy interest rate hikes relative to longer-duration bonds. Just as they closely track interest rates up, so too on the way down.
- The outlook for interest rates is more skewed to the downside in the next 18 months compared to the previous 18 months. With MMFs, the associated reinvestment risk could make it more difficult to lock in higher rates relative to longer-duration bonds if interest rates are expected to fall.
- Real rates remain low or near zero in many major developed markets even as central banks have aggressively hiked. For some, MMFs and other low-risk income strategies may not suffice if higher real yields are required. Purchasing power will erode over time without capital growth, which is non-existent in cash strategies.
As a recession is delayed and peak interest rates are nearing, investors are increasingly pricing in a ‘higher for longer’ scenario. However, relying on any one scenario or market trend - such as MMFs in a ‘higher for longer’ interest rate environment - for income could leave them highly vulnerable.
Investors should closely monitor the interconnectivity of the return drivers in their income-focused strategies at a time when volatility and dispersion are rising. Taking a step back and reassessing the source of income in their portfolio now will pay off in the future, no matter which macro scenarios emerge.
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