Key takeaways
- Seeking shelter in cash may seem safe, but it comes with hidden risks.
- In 2023 and beyond, duration no longer equates to pain as it did in 2022.
- The Fed's path forward is uncertain, but the tightening cycle is likely nearing an end.
- Investors should consider the reinvestment risk of cash-related investments.
- A heavy allocation to cash could result in missing out on captial appreciation opportunities.
Lately, there has been an ongoing debate among bond investors over seeking shelter in cash versus extending duration by allocating more to diversified fixed income products. Considering today's volatile investing environment, it may seem like “parking in cash” is the safe move. But sitting on the sidelines can actually be a dangerous game. Rather, it is time to start thinking longer-term.
Look forward, not backward
The first lesson in bond investing played out in 2022. Interest rates went up — and bond prices fell, causing dramatic declines in the overall fixed income market. In fact, 2022 marked the beginning of one of the most aggressive tightening cycles in history. The investor experience of this dramatic repricing of the bond market meant that adding duration of any kind in high-quality fixed income products absolutely burned them in 2022 and the first half of 2023.
With this in mind, it's understandable that investors would feel compelled to seek shelter in cash and shy away from adding duration. But we believe the tightening cycle is likely nearing its end. If the economy begins to show signs of weakness and the Fed starts to cut interest rates, the opposite of the “interest rates up — bonds down” story could occur. In that case, the price of longer-maturity bonds will increase more than short-term bonds and cash. In other words, high-quality duration could prove to be one of the most important hedges for a bond portfolio today.
Higher duration no longer equates to the pain that it inflicted on investors in 2022. With a target fed funds rate of 5.25-5.5% today, high-quality duration has become more of an “insurance policy.” (The same couldn't be said during the days of zero interest-rate policy (ZIRP) where there was simply no “cushion” to offset the negative impact on bonds from rising interest rates.)
What are the Fed's next steps? Ayers Rock vs. Matterhorn.
While nobody can predict with any degree of certainty when the Fed's rate hiking cycle will be over, there is a strong consensus that it is much closer to the end than the beginning. To us, the important debate is whether the Fed will keep rates “higher for longer” or if it will overtighten (or if it already has overtightened). We like to use the analogy of Ayers Rock vs. Matterhorn. Ayers Rock is a massive sandstone monolith in Australia that rises out of the ground abruptly and is relatively flat on top. Matterhorn on the other hand is a near-pyramidal peak in the Swiss Alps.
In the Ayers Rock “higher for longer” scenario, the Fed would keep interest rates at high levels indefinitely in an effort to allow its efforts to filter into the economy and contain inflation. In the Matterhorn “overtightening” scenario — the Fed would increase rates to high levels to get inflation under control, followed by steep rate cuts.
Of course, it is important to reiterate that nobody knows for sure what the Fed will do. The hypothetical Matterhorn may rise more steeply than expected or the Ayers Rock may plateau for longer. As is the case for any investment — be it cash and equivalents, short-term bonds, or long-term bonds — there are risks. Cash and equivalents generally involve the least risk, particularly if the Fed tightens further or leaves rates higher for longer. But they also offer the least potential return. Short-term bonds generally offer higher yields than cash and equivalents, and because of their short duration, tend to have less sensitivity to interest rate movements — either up or down. Bonds and fixed income funds with longer maturities (generally 10 years or longer) can offer higher returns, but as was the case in 2022, can lose value when interest rates rise. Bonds are also subject to credit risk (the risk that a bond's borrower can't make its payments) and prepayment risk (the risk that the lender chooses to pay the bond off early, depriving investors of potential interest).
Importantly, while Ayers Rock and Matterhorn are starkly different in shape — they both end the same way… declining. Regardless of the scenario, we believe rates are likely to move directionally downward over time. Simply put, the potential risks for adding duration to a portfolio are going down.
The risks of sitting on the sidelines
Granted, Fed Chair Jerome Powell has publicly indicated that rate cuts are not likely to occur until late 2024 or early 2025. This may make investors believe they have plenty of time to park in cash and then extend duration later on.
The problem is, the Fed is data dependent — and if there is any lesson to be learned this decade, it's that global macro and geopolitical issues can lead to unpredictable, swift changes in policy. Furthermore, while the economy has shown signs of resiliency in 2023, the risks of future weakness are far from over. The Economic Indicator survey published by Bankrate in July showed that economists see a 59% chance of a recession by July 2024. Similarly, a survey of economists published in August by Reuters found the median probability of a recession within a year to be about 40%. While the conversation has shifted dramatically from that of a recession being an absolute certainty to now merely a strong possibility, it is too early for the Fed to spike the football.
If interest rates do fall, those seeking shelter in cash and equivalents will find themselves needing to reinvest at lower rates. By allocating more to high-quality, longer-term investments, investors are less exposed to this type of reinvestment risk. In other words, those who are “parking in cash” will need to constantly monitor the “parking meter.”
Furthermore, while cash-related investments are less sensitive to interest rate movements — they offer virtually no opportunity for capital appreciation. That is not the case for the broader bond market. With the repricing of fixed income securities over the past year and a half, longer-duration bonds can be bought at a deep discount to par value. And in the case of falling rates, these longer-duration bonds can have a positive impact on an investor's total return. If rates do rise, today's higher yields mean that bonds should be able to absorb some of the pain without leaving investors with large losses.
Conclusion
Currently, cash-related investments offer value in terms of liquidity and may provide a sense of comfort to investors burned by bond market losses in 2022. However, with the Fed's rate hikes likely nearing an end, allocating to intermediate or long-duration bonds will lock in an attractive level of income. And with possible economic weakness and/or rate cuts on the horizon, a portfolio of high-quality, diversified fixed income investments may provide generous total returns.
