Cash yields of 5 per cent have been a “beautiful thing” but investors need to look beyond the short-time, good-time allure now for longer-term fixed income returns, a new Wellington Management paper argues.
The Wellington analysis found bonds significantly outperformed cash in every three-year period after the last interest rate rise in all US Federal Reserve hiking cycles since 1983.
And bonds held their own against cash during the initial year following the first Fed hike in every cycle over the same 40-year period while subsequently delivering better three-year cumulative returns.
“While it’s easy to get attached to high-yielding cash, especially when it yields more than some bonds, it’s also important to understand why it may be time to move into bonds,” the Wellington study says. “The bottom line is that holding cash while waiting until there’s more certainty in the economic outlook, the Federal Reserve’s (Fed) path, or the geopolitical environment could cost total return relative to bonds based on the past six interest-rate hiking cycles.”
Authored by Nanette Abuhoff Jacobson and Patrick Wattiau – respectively, Wellington global investment and multi-asset strategist, and investment strategy analyst – the ‘Why cash won’t cut it for long: the case for bonds’ says the results hold three key lessons for investors.
Firstly, the through-the-cycle historic outperformance of bonds suggests the optimal time-frame for holding cash is narrower than many might anticipate.
“Even though some bonds have lower yields than cash, they’ve benefited materially more than cash in the past six Fed rate-hiking cycles on average,” the study says. “Since the market anticipates the next easing cycle, much of the positive returns accrue around the time of the last hike.”
Furthermore, corporate bonds have provided a superior “return profile” on average compared to other fixed income sectors.
And, finally, the Wellington paper says an “incremental” shift from cash to bonds carries less risk than some investors may expect.
“Even if the Fed keeps hiking, our analysis indicates that bond returns would be comparable to cash in the short term, and bonds would outperform longer term based on past cycles,” the study says.
On the downside, Jacobson and Wattiau admit this time “could be different”.
“The Fed’s inflation fight today is tougher than it has been in past economic cycles, so the Fed may keep hiking rates or may need to stay on hold for longer at these higher rate levels. Recent concerns about federal debt could also weigh on US Treasuries and increase term premia in long bonds.”
It could get ugly.