As interest rates climb, consider a cash-management strategy to get higher yields

THE US economy contracted again in the second quarter of the year. While 2 consecutive quarters of negative growth is often considered a recession, the National Bureau of Economic Research (NBER) has yet to declare a US recession.

Regardless, red-hot inflation which prompted the US Federal Reserve to hike rates aggressively has raised the risk of a recession significantly.

Amid the challenging macroeconomic environment, global equity markets have sold off intensely and the slump in risk sentiment may have also pushed investors to set aside more cash.

However, we believe that it is not ideal to hold too much cash in today’s environment. With the high level of inflation, holding a lot of cash in bank accounts would quickly erode the real value of your savings.

To counter this, investors with excess cash can consider instruments that can provide higher interest rates. One way to achieve this is to create your own cash-management portfolio.

Earning higher yields on cash

A cash-management portfolio serves as an alternative to traditional bank deposits, earning higher yields whilst still providing investors with a decent amount of liquidity. It typically invests in fixed income funds, such as money market funds and short-duration bond funds, which are of low risk.

While cash-management solutions are not difficult to find nowadays thanks to robo-advisers, a do-it-yourself (DIY) portfolio offers greater flexibility. Investors can choose exactly what to invest in based on their risk profile and desired yield – the decision is entirely up to you.

Besides, crafting your own portfolio means that you can potentially save on annual fees which may be charged by robo-advisers.

However, the difference between cash-management solutions and deposit accounts from banks is that the former is not covered by the deposit insurance scheme administered by the Singapore Deposit Insurance Corporation (SDIC).

DIY your cash-management portfolio

There are a plethora of products which can serve as building blocks for investors who want a DIY solution for cash management. Furthermore, funds typically offer a choice of accumulation or distribution share classes, which means you can choose to receive a payout, or reinvest the income back into the fund to generate additional capital growth.

To build a cash-management portfolio, investors can follow a 3-step approach. First, select an anchor for the portfolio. We define anchors as lower-risk funds, which tend to generate reasonable returns at relatively lower volatility, and hence can serve as a stabiliser for the portfolio. We think that investors can consider bond funds with a duration of less than 12 months such as the LionGlobal New Wealth Series – LionGlobal SGD Enhanced Liquidity.

Second, add yield enhancers into the portfolio. We define yield enhancers as funds with exposure to higher credit risk. As the name suggests, they are included to provide higher yields for the overall portfolio. In the current macro environment where inflation is expected to stay high and rate hikes could potentially be faster-than-expected, we believe that it is important for investors to also keep a short-duration exposure. Check out funds like the United SGD Fund and LionGlobal Short Duration Bond, which have an average credit rating of investment grade and a duration of less than 3 years.

A word of caution: Avoid high-yield bond funds as they are too volatile and take on significant credit risk, which affects their ability to play an effective role in a low-risk cash management portfolio.

Third, depending on your risk profile and desired yield, mix and match the funds to form a cash management portfolio. A conservative investor should allocate the majority of the portfolio (for example, 80 per cent) into lower-risk funds, which can serve as an anchor. For instance, a portfolio with 80 per cent invested in the LionGlobal New Wealth Series – LionGlobal SGD Enhanced Liquidity and 20 per cent in the United SGD Fund could generate an indicative return of 1.5 per cent a year (net of fees) in SGD terms, beating out interest rates on bank savings deposits. The maximum historical drawdown for this portfolio is -0.3 per cent, which happened during the March 2020 Covid-19 market crash.

Meanwhile, investors who want to undertake more risk could allocate into funds with higher credit risk, which we defined as yield enhancers. Do note that in return for potentially higher returns, investors will have to accept higher volatility and greater risk of capital loss.

As the risk of the portfolio increases, we suggest having a greater variety of underlying products for diversification purposes. There are also idiosyncratic risks relating to each fund manager, hence you should ideally want to diversify across different fund managers as well.

Making idle cash work harder

All in all, cash management-portfolios present investors with an opportunity to generate higher yields on their idle cash. There are many combinations of exposures, and a DIY approach gives you flexibility to tailor the portfolio to your own unique yield requirements.

The Fed is expected to keep up with rate hikes throughout the rest of the year. The rising-rate environment enables short-duration funds in particular to reinvest their assets into higher-yielding bonds.

We reckon that investors with a DIY cash-management portfolio can benefit with higher yields as interest rates continue to climb.

The writer is senior research analyst of the research & portfolio management team at FSMOne.com