Portfolio construction

Stashed in cash? Fed rate cuts favor fixed income

April 28, 2024 - 3 min read

Vice President, Portfolio Consultant – Natixis Investment Managers Solutions

Whether it’s this summer, this fall, or next year, Fed cuts seem to be on the horizon. That means cash returns could be coming down. Our portfolio data and conversations with clients both suggest that meaningful levels of excess cash remain on the sidelines. Some of this cash will eventually make its way into the equity market, but a fair amount is held by defensive-minded investors or in the defensive sleeve of diversified investors. If we didn’t have an inverted yield curve or the lingering scars from 2022’s drawdown, this money would have otherwise found a home in fixed income. For many, the enticing combination of higher yields and little to no interest rate volatility has been hard to pass up.

An observation worth repeating: the headline yield of a CD or money market fund requires locking your money up for an entire year. A lot can change in a year! Let’s instead, for the sake of argument, focus on a one-month time horizon. Your annual cash yield of 5.4% becomes 0.44% a month. That’s a $437 return on a $100,000 investment. Starting to feel less profound, isn't it? Meanwhile, investing in a 10-year Treasury bond gets you an annualized yield of 4.6% at the time of this writing. Over a one-month time horizon, this represents roughly $374 for a $100,000 investment: $63 less than the cash allocation.

$63 insurance policy?

The higher bond yields scenario isn’t the only risk out there. There is also a risk to no action. In exchange for earning that extra $63 per month, you sacrifice the insurance policy that high-quality duration typically provides: having a portion of your portfolio that goes up when equities go down. Everyone remembers 2022, but let’s rewind the clock a little further and see how that $100,000 bond investor would have fared in some other major equity drawdowns.

Source: FactSet, Natixis Investment Managers Solutions

The bond investor outearned the cash investor by $7,300 in 1998, $16,500 in 2002, $10,900 in 2008, $11,600 in 2011, $6,300 in 2015–16, and $7,500 in 2020. Sort of puts the $63 in context. When the roof collapses, it’s nice to get a check to help defray the costs.

How low can cash go?

How much lower are cash returns expected to be? Looking at forward rates, we can get a sense for a time series of future 1-month Treasury yield expectations over the next two years. The $437 monthly income falls to around $400 by year end. By the summer of 2025, it’s below the current monthly yield from investing in the 10-year Treasury bond. If you think the monthly return from cash is attractive, at what level does it start to get unattractive? If you think the insurance policy is too expensive, at what level does it start to make sense?

Monthly cash returns ($100,000 Investment)

Source: Bloomberg, Natixis Investment Managers Solutions

Remember, there are still two paths to Fed cuts. Either inflation has moderated and there’s no reason for the Fed to maintain restrictive policy, or we finally get a growth scare. It’s hard to imagine the latter scenario with recent upside growth surprises, but both are possible. In the meantime, historically attractive cash returns will very gradually erode. And the $63 insurance policy could prove to be a wise investment.

For those who have increased duration in a fixed income portfolio over the past several months, this means staying patient through recent interest rate volatility. For the defensive investor with large amounts of cash on the sidelines, it means putting at least a portion of that cash to work in high-quality duration. And for those waiting for a better entry point to deploy cash into fixed income markets, cross your fingers and hope you don’t have to file a claim before then.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Natixis Investment Managers, or any of its affiliates. The views and opinions are as of April 18, 2024 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted, and actual results may vary.

All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided. Investors should fully understand the risks associated with any investment prior to investing.

Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.

Foreign and emerging market securities may be subject to greater political, economic, environmental, credit, currency and information risks. Foreign securities may be subject to higher volatility than US securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets.

High yield bond spread, also known as a credit spread, is the difference in the yield on high yield bonds and a benchmark bond measure, such as investment grade or Treasury bonds. High yield bonds offer higher yields due to default risk.

Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price.

Interest rate risk is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.

Duration risk measures a bond's price sensitivity to interest rate changes. Bond funds and individual bonds with a longer duration (a measure of the expected life of a security) tend to be more sensitive to changes in interest rates, usually making them more volatile than securities with shorter durations.

Plus sectors refer to additional fixed income sectors some strategies invest in such as high yield bonds, emerging market bonds, floating rate bank loans, and non-US dollar bonds, to seek greater diversification or yield potential.

The yield spread is the difference in the expected rate of return between two investments.

Unlike passive investments, there are no indexes that an active investment attempts to track or replicate. Thus, the ability of an active investment to achieve its objectives will depend on the effectiveness of the investment manager.

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Provided by Natixis Distribution, LLC, 888 Boylston St., Boston, MA 02199. Natixis Investment Managers includes all of the investment management and distribution entities affiliated with Natixis Distribution, LLC and Natixis Investment Managers S.A. Natixis Advisors, LLC provides advisory services through its division Natixis Investment Managers Solutions. Advisory services are generally provided with the assistance of model portfolio providers, some of which are affiliates of Natixis Investment Managers, LLC.

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