Sitting on cash could cost high net worth investors dearly

High net worth investors who hold a large percentage of their savings in cash or money market funds risk missing out on the potential for sizable gains in bond markets.

Reviewing the past five US rate-hiking cycles reveals that, three years after they peaked, cash delivered an average return of 15 per cent, compared with 32 per cent for investment-grade corporate bonds.

“Importantly, more than a third of this return was generated in the 10 months following the last rate hike,” underlines Scott Steele, Head of Fixed Income Business Development, Europe and Asia at fund manager, Capital Group.

European bond markets and interest cycles tend to follow the patterns in US markets closely.

Once interest rates have peaked, there is usually little — if any — further upside for returns on cash and money market funds. If, as widely expected among the investment community, rate cuts happen next year, attractive returns will likely come from longer-dated bonds. Lower interest rates typically see a rise in value of longer duration bonds that pay a fixed-rate coupon. Meanwhile, returns on cash will tend to track falling central bank base rates.

For an individual close to retirement, these returns on bond markets could make a big difference to the final value of their pension pot. Favourable current conditions also offer the opportunity to secure attractive returns for years to come by locking in attractive yields on instruments like investment grade corporate bonds

These temptations notwithstanding, difficult markets in 2022 and the current uncertainty over interest rates, inflation, the economy and geopolitics has prompted many investors to sit on their cash savings. They see cash and money market funds as safe and, moreover, for the first time in many years, they actually offer a compelling rate of interest.

This caution has seen investors park a record $10tn in money market funds in the third quarter of 2023, according to the Broadridge GMI integrated dataset.

But being heavily invested in cash is potentially dangerous for long-term investors looking to grow their portfolios — particularly as the markets are likely to have arrived at or are near a turning point.

Peak interest rates?

Few analysts anticipate further interest rate rises from the European Central Bank (ECB) and the Bank of England (albeit with some possibility of a very modest final one from the US Federal Reserve). All three institutions are expected to start easing monetary policy next year, with the ECB likely to go first and the Bank of England last.

Therefore, the main debate is balanced between central banks maintaining high interest rates for longer related to a soft landing for the economy or cutting aggressively next year due to a deeper than expected recession. Historically, interest-rate cycles tend to turn downward quickly as central banks underestimate the impact of their monetary policy on the economy.

“Investment-grade or government bonds can do well in either of these scenarios. Even if the economy tips into a deep recession, longer-dated corporate bonds issued by financially strong companies can still do well,” suggests Steele.

The risk of default on high-quality government bonds is minimal, but there is a slightly greater possibility of that happening with investment-grade corporate bonds. However, investors are rewarded for taking the risk with higher yields.

If central banks cut interest rates faster than markets expect, then bond markets will rally quickly. However, if the ‘higher for longer’ narrative prevails, then investors should have more time to build positions in these markets.

There is a growing consensus among analysts that interest rates are on the way down next year in Europe and the US due to falling inflation and signs of slowing economic growth.

In an interview with Bloomberg on November 3, Goldman Sachs Group’s Head of Asset Allocation Strategy, Christian Mueller-Glissmann, said bonds are looking attractive and are set to beat cash over the next year as inflation cools and central banks stop increasing interest rates.

UBS, meanwhile. is forecasting US interest rate cuts by the Fed of 2.50-2.75 percent next year from the current level of 5.25-5.50 percent. This is four times more than expected by market participants as UBS foresees the country slipping into recession.

Cautious investors who worry that bond markets may fall further can pursue a ‘dollar-averaging’ strategy: that is, invest their cash in monthly instalments over, say, a 12-month period. If markets do fall, investors can pick up bonds at steadily cheaper prices, while enjoying a gradually increasing exposure if they rise.