Latest Cash Smart Projections
We are revising our projected yield for the Cash Smart Enhanced and Ultra portfolio from 1.1-1.3% and 1.7-2.0% (September 2021) to 1.2-1.4% and 1.9-2.1% (October 2021) respectively. Projected yields for the Cash Smart Core portfolio remain at 0.7-0.8%.
September chills affect all fixed income markets
September saw the first meaningful correction for the equity market this year, but it was also a month of volatile and negative returns for fixed income generally. This is attributable to interest rates and yields creeping up steadily, in response to persistently high inflation and the resulting increased likelihood of the Fed unleashing a tightening regime, starting with the tapering of its quantitative easing program that have been ongoing since the outbreak of the COVID-19 pandemic last year.
There is a clear, positive correlation between risk and returns, and asset classes with higher risks fell more during this correction. Within the fixed income space, the rising yields meant that duration risk was the primary driver of negative returns.
Although stated in years, duration is not simply a measure of time. Rather, duration signals the likelihood of the price of your bond investment fluctuating when there is a movement in interest rates, whether up or down. The higher the duration number, the more sensitive your bond investment will be to changes in interest rates.
If you hold a bond to maturity, you will receive the par or face value (original investment) back with the principal, as long as the company does not go bankrupt or refuses to pay, or in other words, it is in default. However, if you sell the bond before maturity, then your selling price will be determined by the prevailing market interest rates and the duration of the bond.
If one holds a bond fund with a duration of 10 years, and the interest rate goes up by 1%, then the fund will fall 10% in value. However, if the interest rate goes down by 1%, then the bond fund will rise 10% in value if duration is 10 years. This is why 100% fixed income portfolios tend to have longer duration and (of course, while still being less volatile than equities and riskier asset classes) are more volatile compared to short duration bond funds which typically invest for less than two years to maturity when the par value is returned. Similar to conventional bond funds, short duration bond funds will also be affected by interest rates, with a 1% increase in yields resulting in a 2% fall in value if their duration is 2 years.
And this is exactly what happened with the short duration bond funds in the month of September. Of course, some funds did better and others fared worse depending on which geography, where in the credit risk spectrum they had exposure to, and depending on the duration risk they were taking as even short duration bond funds can have duration ranging from less than 1 year to above 2-3 years.
More recently, the impact of some Chinese real estate sectors, and other sectors disrupted by COVID-19 may have also affected the mark-to-market pricing (not realised losses but losses that sometime can be temporary due to market price movements). We may see some retracement or recovery in some portions of the portfolio among the short duration bond funds that are exposed to these temporary pullbacks.
Regardless, interest rate movements also provide an opportunity for the short duration bond funds to reinvest the maturing bonds at a higher rate, allowing for the expected yield of the funds, and hence, the Cash Smart portfolios to go up instead of going down. Rising yields therefore have two sides to the coin -- one short-term negative, and another, long-term positive.
Cash Smart Historical Performance
While Cash Smart Core has continued to deliver a positive return in September, Cash Smart Enhanced and Ultra underwent a month of negative returns as the portfolios trudged through a hostile market sentiment. Weighed by rising yields in the US and risk of Fed tightening and further impacted by the souring of sentiment towards China and the Asian High Yield market, this has led to greater volatility in the fixed income market. Concurrently, the yields of the Enhanced and Ultra portfolios have gone up to reward investors who are taking higher risks in the prevailing market environment. The recent market volatility underlines the importance of choosing a risk appropriate portfolio even between the different Cash Smart Portfolio, rather than chasing after the highest yield.
The Ultra has the highest projected yield based on the current investment yields of the underlying funds and short duration fixed income positions. The Core is obviously the safest and has continued to deliver a consistent and good yield with virtually no volatility since its launch more than 17 months ago. With Enhanced positioned well as the best of both worlds, there is a sliding scale of risk, duration, returns, and volatility among the three Cash Smart portfolios. In creating the three options, we had received feedback from clients with the reality that people have varying needs and our clients have used the three Cash Smart portfolios for their specific needs and according to their risk profile. Overall, all three Cash Smart portfolios have generated positive returns despite the September pullback for Enhanced and Ultra in Q3 and on a year-to-date basis, as well as since launch, in line with their respective long-term value proposition.
In fact, we have seen a rise in volatility as a correction in May/June was followed by a downward stabilisation of yields in July/August which boosted Cash Smart returns before the correction again in September. The volatility in sentiment was particularly driven by the Asian high yield sector which fell sharply following the continued distress surrounding Evergrande, and concerns over the fundamentals of Chinese property developers.
None of the Cash Smart portfolios had any direct exposure to Evergrande. However, the portfolios were penalised for their allocations into the Chinese real estate sector that were affected by the widespread contagion and negative market sentiment. In response to this, some managers have been trimming down on their exposure to the sector and maintain a more cautious position. However, they remain confident in the opportunities of the Chinese property sector in the medium-to-longer term, given its importance to the Chinese economy, as well as the low tolerance of Chinese policy makers for financial instability.
Update on current interest rate environment
Following the Fed’s remarks during the September FOMC Meeting which signalled that tapering of asset purchases could start as soon as in November, the market saw a continued hawkish rhetoric on monetary fronts -- the 10-year US Treasury rose by 18bps in September, ending the month at 1.49% and have continued to trend higher in October, while projections showed that half of Fed officials expect to start raising interest rates by mid-2022. This is despite the renewed anxieties around COVID-19’s delta variant, and the seemingly slowing recovery in growth and employment. The key risk remains persistently high inflation and how the Fed will react to those inflationary pressures while balancing its need for growth and employment.
Endowus Cash Smart products have ultra-short or short durations and therefore are more defensive than conventional fixed income products with longer durations, especially in an environment of rising interest rates, due to their focus on money market instruments or the short-end of the yield curve with only low duration exposure. Cash Smart solutions also have exposure to credit risk in varying degrees, with Ultra having a higher allocation than Enhanced or Core. This means that they are less anchored to the movement of interest rates and more towards the overall health of the economy, which in an improving economic environment should reduce the risk of credit defaults. In the short run, the movements in interest rates affect the mark-to-market pricing of bonds, but if the same bonds are held to maturity as most of the bonds are in our Cash Smart portfolios, the price will be recovered at par. In the medium to long term, the rising interest rates allow for the funds to reinvest maturing bonds at a higher rate than before, and will lead to a rise in projected yield again.
Projected returns compared to actual returns
Meanwhile, Endowus Cash Smart portfolios have all performed in line with the projected yield of earlier this year. The tables below show the monthly and overall performance (both actual and annualised) of the three portfolios since April 2021, in the past 6 months.
As we have consistently highlighted and published, the return potential of the portfolios is positively correlated to the risk profile of the underlying investments. Cash Smart Ultra takes the most duration and credit risk for higher return potential, followed by Cash Smart Enhanced and then Cash Smart Core. The higher risk taken by Ultra and Enhanced provides more upside to the portfolios than Core, but at the same time, subject them to higher volatility to achieve that higher return. It is hence important for clients to choose the portfolio based on their preferred holding time horizon and the drawdowns that they are willing to withstand in the worst case scenario.
For those seeking stable returns with virtually no volatility then as the chart shows, they should use the Cash Smart Core solution especially for short periods of less than 1 month. The Cash Smart Enhanced portfolio also has relatively stable returns and are expected to consistently provide positive returns beyond 1-2 months. The Cash Smart Ultra is to be used for liquidity management and cash management needs beyond 3~6 months so that you can benefit from the higher yield and returns generated by the exposure to short duration fixed income.
Disclaimer: Any opinion or estimate above is made on a general basis and none of Endowus, nor any of its affiliates, representatives or agents have given any consideration to nor have made any investigation of the objective, financial situation or particular need of any user, reader, any specific person or group of persons.
Past performance is not a reliable indicator of future performance and any projections indicated in this advertisement are not guaranteed and should not be relied upon as an indication of future results. Past performance information may also be out of date. Investment involves risk. As such, the capital value of investments and the income from them may go down as well as up and may become valueless. You should carefully consider whether any investment views and products/services are appropriate in view of your investment experience, objectives, financial resources and relevant circumstances or seek financial advice via Endowus’ platform.
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