In 2022 interest rates rose sharply across Europe, the UK and the US and have continued their ascent, albeit at a slower pace, in 2023.
This has been bad news for conservative investors who tend to hold a larger proportion of their investments in fixed income assets, compared to more adventurous investors.
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The inverse relationship between bond prices and interest rates has led to uncomfortable losses, within conservative portfolios, from supposedly the safest asset – government bonds. Stung by this performance, disaffected bond investors are now considering an asset class whose headline return of more than 5% is looking attractive for the first time in a decade – cash.
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The headline figures certainly look appealing when judged against recent history. Investing in the Barclays benchmark overnight cash index between the end of 2008 and end of 2021 would have returned, in total, less than 6% over 13 years, a measly 0.4% annualised return. Most savers’ deposit accounts fared worse than that. However, is cash as attractive as it appears?
The illusion of headline rates
When thinking in real returns, after inflation is considered, today’s cash rate is actually worse than real rates achieved over the past decade. However, savings have to sit somewhere. Perhaps, therefore, the more pertinent question is, do the cash rates currently on offer compare favourably to other investment opportunities?
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The answer to this question depends on what an investor’s goals are. Is it certainty of returns, liquidity or potential upside? Other important considerations are time frame and the market outlook. And, if trying to time the market, what is the level of confidence in getting this decision right?
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If certainty over future returns, particularly over a shorter time frame, is the most important thing for an investor then cash, fixed-term deposit instruments or short-term high-quality bonds do seem a valid investment option. The benefit of these investments is that volatility from future returns is removed with a known return at the maturity point. However, while in nominal terms this looks like an attractive proposition, in real terms, this certitude will probably lock in a negative real return.
An inversion at the 12-month mark
What about liquidity? Some investors will not want to lock their money away for a fixed time period while others may be opportunistic, waiting for an equity market correction offering a more attractive entry point. With an inverted yield curve, locking up cash for longer actually delivers a lower annualised rate of return than shorter term deposits. For example, the yield on the UK 2-year gilt is currently1 at 5.4% whereas the 5-year gilt offers 4.9% and the 10-year bond 4.6%. This is inverse to what you would normally expect.
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Using the SONIA2 swap curve, inversion occurs around the 12-month point. In other words, available yields increase up to the 12-month mark, before reducing as maturities get longer. The main reason for locking up money for longer, therefore, would be the belief that these rates would no longer be available in a year or two and you wanted to remain in cash over the mid-to-longer term. In this case, it may make sense to forgo some upside in the short-term in favour of getting attractive yields over the longer-term, albeit this introduces some uncertainty risk.
The trade-off between certainty and return
Investing in cash or fixed term deposits means that the upside is limited (as is the downside, excluding defaults), whereas investing in equities or longer-dated bonds (or a blend) still holds the potential for higher upside. Of course, this option also comes with potential downside.
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The CT multi-asset team’s base case is currently for a recession in the second half of this year, which would suggest that equities will at some point become challenged. However, if your time frame is long enough it typically still pays to be invested in equities. Historically, if one was to hold investments in the US equity market for 10 years or more, then there is around an 89% chance of a positive return in real terms (above inflation) and, over the past 150 years, you would have made money in real terms 99.9% of the time if you held for 20 years.
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When it comes to timing the market, investing is an imprecise science. Economists have been predicting the next recession for 12 months or more and yet equity markets are up very healthily so far over this period.Â
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High quality fixed income instruments, such as developed market government bonds, have been the scourge of investors’ portfolios over the past 18 months. However, the key reason behind the negative performance, interest rate hikes, looks to be shortly coming to an end. If this is the case, then downward pressure on prices should be reduced. Due to the selloff, yields available on government bonds are now looking attractive in nominal terms, slightly lower than 12-month deposits, but significantly higher than 18 months ago. More importantly, government bonds also offer significant potential upside in the case of a recession.
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If there is a risk off scenario the rush to buy bonds typically pushes prices higher and depresses yields. Using rough bond maths, if the yield on the UK 10-year gilt drops by 2% this would lead to approximately a 20% capital gain for the bond. A pretty impressive uplift to go alongside the coupons paid.
Ready for tactical manoeuvres
In conclusion, it is only the nominal headline cash rate that looks attractive at the moment. We believe that, given the selloff in fixed income markets through 2022, there are other more attractive assets to invest in. If clients are looking for certainty of returns, then cash may be the best option, however, that is likely to lock in negative real returns. For those with a longer investment timeframe, willing to accept of the possibility of greater volatility in return for a higher potential return, then equities may deliver a better outcome. High quality fixed income sits in-between these options with relatively attractive yields and decent potential upside if a recessionary or other risk-off event occurs.
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From an active multi-asset perspective, we are currently underweight to equities and overweight to government bonds, awaiting the recessionary scenario to play out. If it does, we would look to lock in the capital gains from our overweight government bond position and increase equity exposure, taking advantage of more attractive valuations. In effect, looking to have the best of all worlds by tactically adjusting the portfolio according to developments in the global economy, in real time. In the past, we have used cash as ‘dry powder’, awaiting a selloff in equity or fixed income markets and indeed this was our position across the range through most of 2022. However, given the further increase in yields, we have recently moved out of cash into government bonds.
1 As at 6 July 2023. Source: Bloomberg
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2 Sterling Overnight Index Average
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All data Bloomberg and Columbia Threadneedle unless otherwise stated
