The cash party: The music is about to stop

Yields on cash have been especially cushy for retail investors, setting the major tone in investor portfolios for the past two and a half years. 

The US Federal Reserve is soon having its own “mic-drop moment,” as the central bank is transitioning from a pause to rate cuts. 

The music is about to stop; the cash party that everyone has been enjoying is about to come to an end. This article aims to answer the most commonly asked questions by investors who are considering reallocating some cash to fixed income. 

Why was there a “cash party” to begin with?

The attractive level of cash yield was made possible by the Fed’s 11 consecutive hikes in benchmark interest rates since March 2022.  

In an effort to tamp down on stubbornly sticky inflation, the Fed funds rates were brought from zero to 5.25% and have stayed at such high levels since July 2023. The magnitude of the hikes made the cycle known as the most aggressive one in the past three decades. 

Now, with inflation seemingly in control and signs of economic weakness starting to show, the Fed is finally ready to stop the music and embark on a rate cut. The cash party is nearing its end.

Why is now the time to reassess bonds?

The short answer is: Reinvestment risk is on the horizon. 

With shorter-term bonds, investors must frequently roll over and seek to reinvest, presenting a reinvestment risk and the risk of lower future yields. 

Reinvestment risk becomes significant when rates begin to decline, as investors might struggle to find new bonds that meet their yield expectations gathered in the recent past. 

In the past two years or so, the unusually high cash yields prompted investors to over-allocate to cash.  And, during high cash yield periods, fixed income investments are also overlooked. 

Now, fixed income is becoming an attractive option for those seeking to secure yields for a longer duration. The market expects short-term rates to decrease significantly, while longer-term rates remain more uncertain. This scenario has prompted many to rethink their investment strategies and consider alternatives that offer better returns without significantly increasing risk. 

What are the risks and returns of fixed income? 

Higher returns typically come with higher risks, and this holds true when comparing fixed income investments with cash. 

On the return side, global fixed income, which bears a higher risk than cash, has historically outperformed cash throughout policy cycles. Not only do fixed income outperform cash over the long term, bonds have beaten cash most of the time. 

In terms of risks, fixed income carries interest rate risk and credit risk and it can underperform cash in extraordinary times, including the unfavourable market seen in 2022. Longer-term bond prices dropped due to rising interest rates (bond prices and interest rates move in opposite directions). 

The cumulative excess return of global fixed income against cash

From January 2009 to August 2024

Total return on fixed income assets consists of two components: Income and capital gains or losses.

In the past cycles, in the three years following the first rate cut, most fixed income sectors generated attractive total returns, often outperforming cash. This performance is driven by a high starting yield and potential price appreciation due to falling interest rates, enhancing total returns over the period.

Fixed income sector returns after first rate cut

3-yr annualised return

How do I start investing in fixed income?

When considering moving out of cash into fixed income, there are two ways for investors with different time horizons, investment objectives, and risk tolerance to consider.

Taking a baby step forward 

For those looking to move out of cash gradually,  consider adding some short duration fixed income to your portfolio. They are suitable for conservative investors with a relatively short investment horizon of less than two years. 

Our ready-made advised portfolios such as CashUp Simple and Plus come with a mix of money market funds and short duration funds. 

Individual short duration funds are available on Endowus Fund Smart. 

Endowus Fund Smart provides a well-curated selection of individual short-duration funds as follows:

Longer duration options

For those who have a longer investment horizon, and are ready to take on higher duration and interest rate risk, consider the Endowus Flagship 100% Fixed Income Portfolio. This Portfolio offers globally diversified exposure to high-quality fixed income instruments, including government and investment-grade corporate bonds. 

The PIMCO GIS Global Investment Grade Credit Fund, investing only in corporate bonds, provides exposure to longer duration, as well. 

Illustrative fixed income risk and return map of select options

All these options have no lock-up period and offer daily liquidity. Endowus does not charge upfront sales fees and returns all trailer fees to clients as cashback, ensuring the lowest possible cost for our investors.

Select fixed income options on Endowus

Yield to maturity (YTM) is a useful (but not perfect) forward-looking metric for gauging the return potential of fixed income investments. It assumes no active trading and no credit default.

Duration measures the interest rate risk the investment has (the higher duration, the more interest rate risk); it is also closely tied to the longevity of the yield investors can secure. 

Credit quality measures the credit risk the investment has. AAA is the highest credit quality and BBB is the lowest in the spectrum of investment grade rating. 

When should I move to fixed income, or should I wait?

Market timing, whether for bonds, equities, or any asset class, is notoriously difficult and relies heavily on luck.

If you are waiting for longer-term yields to pick up before investing, it means you are betting on an active view that market expectation of rate cuts will be scaled back, perhaps due to inflation overshooting or growth outperforming. 

On the other hand,  waiting for the cash rate to drop below long-term bond yields before moving to fixed income exposes you to reinvestment risk. By the time the yield curve normalises, long-term bond yields may have also dropped, causing you to miss out on better reinvestment opportunities. Instead of obsessing over perfect timing, it's important to focus on two key realities.

The Fed has pivoted 

It is a foregone conclusion that the Fed is shifting to rate cuts, and a return to a normalised environment where cash yielding less than longer-term bonds is expected. 

As of the end of August, the market expects the Fed fund rates to be around 4.35% by the end of 2024, and by the end of 2025, 3.17%, according to the estimates by JP Morgan Asset Management. Cash rates closely follow the Fed fund rates. 

Bond carry is back

Bond carry, in simple terms, refers to the potential return that an investor can earn by holding a bond over a period of time. It takes into account the interest payments received and any changes in the bond's price due to shifts in interest rates.

Fixed income yields are at the highest level since the Global Financial Crisis, during which the zero-interest rate policy was introduced. While it is highly unlikely to see interest rates back to zero, higher starting yield means investors can earn more income from their bond investments. 

Historical US Treasury 2-, 5-, 10-year yields

How do I balance fixed income with other asset classes in my portfolio?

Put your investments in buckets, segmented by when you need the money, and how much risk you can take. 

Fixed income plays an important role in one’s portfolio. First, it dampens an equity portfolio’s volatility, hence should be added for shorter-term goals and more conservative investors. Second, as a portfolio diversifier, bonds can diversify equity risk, especially in an equity market downturn. 

Some cash should be first set aside for rainy-day cash needs. After provisioning for emergencies, the rest should go to a combination of fixed income and equities depending on each individual’s circumstances. 

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The exact percentage for allocation would differ for everyone. It can be started with risk tolerance, asking for the maximum one-year loss one can withstand for a goal. 

After drawing out the bucket and defining the personal risk tolerance, investors can play around with the allocation on Endowus to see which allocation would meet their objectives the best. 

Fixed income: Stay strategic rather than tactical 

Reinvestment risk has impacts on portfolios, and the risk-free cash returns likely won’t last. The market is witnessing an increasing reallocation of capital to fixed income assets. Bond market issuance has been very active, with new issuances quickly snapped up by investors. 

Despite the changing tides, the most important advice for when the rate cut cycles come is to stay strategic rather than tactical. 

High cash rates and market volatility have led many to over-allocate to cash, despite their risk tolerance allowing for some fixed income allocation. 

Now is the time to reassess your asset allocation and move excess cash to fixed income. This will allow investors to match the duration of liabilities while taking advantage of the market’s current gift: higher bond carry.

Bonus round: What are yield curves, and how do they affect my investments?

Typically, investors are rewarded with higher returns for long-term lending due to the increased risks associated with longer time horizons. 

An upward-sloping yield curve is the norm, where longer maturities are accompanied by higher interest rates. This is because longer-term debt carries greater risk, such as inflation or default, over an extended period.

However, there has been a reversal in this pattern, with longer-term bonds paying less than shorter-term ones. This means that investors who took on the additional risk of investing long-term had to accept lower starting yields. 

Yield curve inversion drove the flight to cash

The unusually cushy yields have drawn investors to pile up on cash investments. However, such periods are uncommon and usually short-lived.

In the past two decades, there are two other main episodes of yield curve inversion: one followed the Fed’s hiking cycle from 1999 June to 2000 May to control inflation expectations during the tech bubble boom and the other one followed the Fed’s hiking cycle between June 2004 and June 2006 to cool off the economy and the growing real estate bubble. 

The yield curve inversion this time has again been induced by the Fed’s rate hiking decisions. While unprecedented in terms of its magnitude and persistence, it will not last forever. 

Historical US treasury 6-month and 5-year yields

From January 2000 to September 2024

Over the long term, sophisticated investors start with their financial goals and wealth objectives in mind, which should dictate the bulk of the asset allocation. 

For more help, reach out to our SFC-licensed advisors.

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