Rethinking the Dash to Cash
While higher yields may make cash appealing, higher cash balances may actually reduce your ability to achieve your long-term investment goals.
Key Takeaways
Investors have piled into cash since the start of 2022.
While higher yields may make cash appealing, higher cash balances may actually reduce client’s ability to achieve their long-term investment goals.
Reinvestment risk and the opportunity cost of owning cash relative to other asset classes are reasons we believe clients should consider a multi-asset approach for income investing.
Investors have piled into cash since the start of 2022. In fact, more than $5.6 trillion is sitting in US money market assets today, up $1 trillion from a year ago.1
Though higher yields coupled with a still uncertain macroeconomic outlook may make cash appealing, the potential risk of over allocating to cash is that it may affect investors’ ability to reach their long-term investment goals as compared to other investment options. This is particularly worrisome as we approach the end of the Federal Reserve’s hiking cycle. Going back to the mid-1990s, in the year following the last Fed rate hike, money market funds meaningfully underperformed a wide array of asset classes on average, as the chart below illustrates.
Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Source: BlackRock, Morningstar as of 31 August 2023. Money markets represented by the USD Money market Morningstar fund category. High Yield represented by Bloomberg US HY 2% Issuer Cap TR USD Investment Grade represented by: Bloomberg US Corp Bond TR USD Developed Equities represented by MSCI World NR USD EM Debt represented by JPM EMBI Global TR USD US Equity represented by: S&P 500 TR USD Dividend stocks represented by: MSCI World High Dividend Yield NR USD.. *Last Federal Reserve rate increase: 1) February 1, 1995 2) March 25, 1997 3) May 16, 2000 4) June 29, 2006 5) December 20, 2018.
And the trouble may intensify once central bankers go from pausing rate hikes to cutting rates. While this may not happen in the near-term, markets are currently pricing in approximately 2-3 rate cuts in 2024 in the US.2 But in an environment of falling interest rates, an overconcentration in cash could expose investors to an often underappreciated but potent force: reinvestment risk.
Reinvestment risk: a powerful multiplier
Should the Fed start cutting rates, cash returns may erode quickly as investors are forced to reinvest at lower yields. To better understand this dynamic, we looked back over the last 30+ years to quantify the relationship between starting yield and future total returns.
What may be surprising is that the link between cash yields today and future returns is weak. Why? Because there is no guarantee that prevailing yields one or three months out, when that hypothetical cash-like instrument matures, will still be as high as the initial investment rate. In other words, the durability of cash investments’ return stream is unpredictable. As the chart below illustrates, the dispersion of forward returns for cash at various yield levels is quite wide, and a higher starting yield does not necessarily translate to a favorable three-year return experience.
Index performance is for illustrative purpose only. Investors cannot directly invest into an index. Source: BlackRock, Bloomberg as of 9/30/2023. Cash represented by Bloomberg US Treasury Bill Index. Multi-Asset Income Index Blend is comprised of 33.34% MSCI World High Dividend Index, 33.33% Bloomberg US Corporate Bond Index, and 33.33% Bloomberg US High Yield Bond Index. For illustration purposes only. Yield reflects yield-to-worst (%) for fixed income and dividend yield (%) for equity.
In contrast, for a blended multi-asset portfolio comprised of global dividend stocks, investment grade bonds and high yield, starting yields actually had a much more positive predictive relationship with ensuing three-year returns. This is due to reduced sensitivity to short-term rate policy, brought about by owning fixed-rate investment grade and high yield bonds, which allow investors to “lock-in” higher starting yields for a longer period. This can be a powerful return driver especially when combined with the greater upside potential of equities.
If not cash, then what?
For investors with a longer time horizon, we caution against over-allocating to cash given the associated reinvestment risk relative to other opportunities in today’s unique yield environment. Here are a few areas we favor in our multi-asset income portfolios:
1. Undervalued dividend stocks complemented with covered calls
Dividend equities can offer a nice blend of growth, quality, and stability, along with a steady and often growing cash flow stream. Today, the discount for dividend stocks is extreme, and we believe this group has more reasonable earnings expectations compared with growthier parts of the market that have been the big year-to-date winners.
Complementing dividend stocks with a covered call strategy enables investors to take advantage of elevated volatility. Covered calls are a strategy in which investors own the underlying stock and sell away upside after a certain share price is hit, leaving room for some capital appreciation while collecting additional income via the option premium. While we see potential for gains across our equity holdings, we do not believe an environment of tight monetary policy, reasonably low economic slack, and still elevated uncertainty is one where large upside moves in stocks are likely. Combined with an elevated volatility regime, this is precisely the environment where covered calls can be most valuable.
2. Select opportunities in higher yielding credit
The current yield profile of the US High Yield market continues to offer attractive carry and overall strong fundamentals. However, index levels don’t tell the full story as dispersion continues to sit at elevated levels. In our Multi-Asset Income model portfolios, we recently added to a strategy with exposure to “Fallen Angels,” a sub-set of High Yield bonds that were recently downgraded from investment grade. This strategy provides an up-in-quality access point to higher yielding parts of credit markets, without sacrificing significant yields. For instance, as of September 30, 2023, Fallen Angels had a yield of 8.33% and 79% BB-rated exposure (the highest quality part of the High Yield market) versus a yield of 8.91% and only 47% BB-rated bonds for the broad High Yield index.3
It may be the time to consider moving away from cash investments
Today’s inverted yield curve wherein the front-end is out yielding longer duration bonds has tempted many to pile into extremely short-term cash investments. This would be a mistake, in our opinion. With a Fed that has been vocal about nearing the end of its hiking campaign, the era of ultra-high short-term rates may be coming to a close. As the chart below illustrates, yield curves don’t remain inverted for long periods of time. Since 1971, the yield on the 2-year Treasury has only been higher than that of the longer-dated 10-year Treasury 15% of the time.4
We think investors could benefit from locking in income opportunities that can support them for the next several years, not the next several quarters. By investing in a multi-asset income portfolio with a moderately longer-duration profile, investors have an opportunity to tap into today’s higher yields and potentially realize price appreciation as well.