Don’t wait too long to invest in bonds
Yields for the asset class today are the highest they have been in decades
IN SAMUEL Beckett’s landmark play Waiting for Godot, we see lead characters Estragon and Vladimir vacillate between hope and despair, action and inaction – all while waiting for a man named Godot whom they seem to hardly know.
As with Beckett’s comedy of the absurd, the financial world has hunkered through a period of aggressive rate hikes, paralysed by investment inertia – all while waiting for a man named Jerome to finally cut rates and bring an end to the reign of cash.
While much can be studied about the latest Fed hiking cycle and its potentially far-reaching impact on both financial markets and the real economy, we believe that complexity can sometimes lead to analysis paralysis – blinding investors to the opportunities hiding in plain sight. Bond yields today are the highest they have been in decades, boding very well for future returns in the asset class.
This stepwise shift in rates over a short period has propelled yields on investment-grade (IG) credit (with historically low default rates) to altitudes of rarefied air (more than 5 per cent in nominal terms and over 2 per cent in real terms). Since the advent of quantitative easing (QE) following the 2008 global financial crisis, in only 12 per cent of the time did yields on high-quality credit exceed the 5 per cent handle, attesting to how limited this window of opportunity is.
Furthermore, if you consider this from a real (inflation-adjusted) yield perspective, the window looks even tinier. Real yields have surpassed the 2 per cent threshold in only 2 per cent of the time over the same period, where much of it was in fact spent in negative territory. While the world debates whether inflation would eventually settle at 2 per cent or 3 per cent over the next decade, let’s not miss the fact that IG credit yields at present would beat inflation in either scenario.
Cash no longer king
Yet, it is not the narrowness of the window alone that underpins this golden opportunity; it is the fact that the Fed – as well as other central banks around the world – have indicated that the monetary policy cycle is about to turn. The debate around a lower-yield environment is therefore not a matter of if, but when. The Fed in particular has clearly illustrated through its dot plot that it expects a declining yield environment over the next three years.
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In the nearer term, expectations are building that the Fed will carry out its first rate cut since the pandemic this month, suggesting that the heyday of high bank deposit rates and T-bill rates is coming to an end.
Unintuitively, this implies there could be more “downside” staying in cash instead of fixed income. Should we be on the verge of a cutting cycle, it is often short-term cash rates that fall the fastest and largest after the first cut. Cash always faces the highest reinvestment risk at the turn of the policy cycle, making it no longer apt to just “T-bill and chill” for the foreseeable future.
Not if, but when
Credit, on the flipside, has the opposite outcome. By securing prevailing yields for a longer duration, investors (a) preserve the high-coupon yields available today for a longer term, and (b) benefit from price gains as rate cuts lower the yield environment on aggregate. Looking at policy cycles since 1984, the cumulative returns of credit following the last hike in the cycle on average far exceed that of cash over a three-year horizon.
The best part? Precision in the timing of entry for bonds seems almost unnecessary once rate cuts approach the horizon. Based on the five full policy cycles over the last 40 years, investors who choose credit over cash – whether it is just before the last hike, at the last hike itself, or all the way up to the first rate cut – see outsized cumulative excess returns of credit over cash over the same subsequent three years.
We believe that the main hindrance in the bonds-versus-cash argument is the fact that cash yields are high at present, limiting the pickup in yield one would get switching into bonds. Yet, history suggests that these are precisely the periods that cash returns are at their most perilous.
Over more than two decades of data, we see that high cash yields could precede some form of unexpected downturn, resulting in central banks having to intervene and slash interest rates quite drastically in an unexpected way.
Building a resilient portfolio
How should we best construct a fixed-income portfolio under the circumstances? We believe that a credit duration barbell is well-suited for this environment, with outsized exposure in high-quality IG credit in both the (a) short-end (one to three-year duration segment) and (b) longer-end (seven to 10-year duration segment).
On the shorter end, since cash rates are the most impacted once cuts ensue, this is the segment that stands to gain with more certainty from a repricing of the rate environment and can act as a cash alternative that minimises reinvestment risk.
On the longer end, investors benefit from much wider credit spreads (higher risk premiums), while also having a higher sensitivity to a declining rate environment – introducing the potential for capital appreciation for bond holdings. On balance, this should give an average portfolio duration of five to seven years, setting the investor up for steady income generation for a longer term to come, knowing that the high yields available today may no longer be here tomorrow.
Today, it appears that investors are waiting for their own Godot – choosing to switch to bonds only when there is absolute certainty about a future in which cash no longer provides any meaningful returns.
Let us not forget that Beckett’s play concludes without Godot himself ever arriving; investors who wait for certainty would find no such thing, and even if there was, that certainty would certainly come with a missed opportunity as efficient markets quickly price what’s known before one can act.
Seeing as we’re now closer to the end of the rate-hiking cycle, we do expect the Fed – unlike Godot – to really show up with rate cuts, affirming our call to declare bonds king over cash for this turn in the policy cycle.
The writer is senior investment strategist at DBS
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