What to do when the allure of cash fades

November 21, 2024

Lower interest rates will reduce future returns on cash. Portfolio managers Tatjana Greil-Castro and Ian Horn explain how an allocation to short-duration corporate bonds could help investors willing to take modest interest rate and credit risk to maintain a potentially attractive yield on their capital.

For many credit investors, higher interest rates from 2022 onwards led to a ‘dash for cash’ given the opportunity to generate decent returns for little risk.

Policy rates have since peaked, however, with a broad sweep of interest rate cuts across developing and developed markets, including from the US Federal Reserve.

Cash deposit rates typically move in line with policy rates, which means cash is set to become a less attractive investment proposition in 2025. As the potential returns from cash decline, investors could consider short-dated corporate credit as an alternative.

Lower policy rates and steeper rate curves

While rate cuts are good for borrowers, they are less positive for savers and investors in cash deposits or very short-dated fixed income. As interest rates fall, so do the interest rates paid on these products and instruments. In this sense, cash deposits are essentially floating-rate products that become more attractive as rates rise, but less so when rates fall.

Through 2022 and 2023, central banks hiked rates to slow economic activity and bring inflation under control. With inflation now close to central bank targets, but signs of economic weakness in Europe and questions over whether China will meet its growth objectives, central banks are expected to cut rates steadily through 2025.

In the second half of 2024, we have seen a re-steepening of rate curves – a welcome return of ‘term premia’. This is important as investors are starting to be paid in yield for extending duration.

As policy rates fall further, we expect the re-steepening trend to continue, and yields on cash deposits to continue to fall below those offered by short-term bonds. For yield-sensitive investors, we expect a return to an environment where investors look to credit to enhance the yield on their cash.

Figure 1: Yield curves are normalising

Forecasts mentioned are not a reliable indicator of future results.

Source: Bloomberg, data as of October 31, 2024. Theoretical future curve based on Bloomberg’s Market Implied Policy Rates (MIPR – 2 years ahead) as of October 31, 2024, and 100 basis points of curve steepness between Fed Funds Rate and 10-year Treasury yield.

Moving from cash to short-duration credit

In reallocating from cash to short-duration credit, investors can take comfort from a higher level of visibility over potential returns compared to other credit markets and asset classes. As Figure 2 illustrates, there is a strong correlation between starting yields in short-dated credit and realised performance over the following 24-months (a period in which the bonds are likely to mature and be repaid).

Figure 2: Visibility over returns

Past performance is not a reliable indicator of current or future results.

Source: ICE Data Platform, as of December 31, 2023. Updated annually. 1. ICE BofA 1-3 Year US Corporate Index (C1A0). 2. ICE BofA 1-3 Year Euro Corporate Index (ER01). Muzinich views and opinion for illustrative purposes only, not to be construed as investment advice. Indices used represent best proxies for US and EUR short-dated corporate bonds.

Corporate credit also offers investors a potential yield pick-up over government bonds. Furthermore, we believe an active management approach allows us to create strategies that can optimise yields through credit selection, sector positioning and regional allocations.

Staying in short-dated credit can offer these benefits whilst allowing investors to limit price volatility caused by movements in interest rates. We believe this is a valuable attribute in an uncertain market environment.

Short-dated credit strategies often offer daily liquidity, with differentiation coming via their geographical focus and credit quality. For more conservative investors, an allocation into a pure investment-grade strategy could be an option, while those with a higher risk appetite might consider a crossover strategy (combining investment grade and high yield) or a pure high-yield strategy.

“We believe an active management approach allows us to create strategies that can optimise yields through credit selection, sector positioning and regional allocations.”

 

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. References to specific companies is for illustrative purposes only and does not reflect the holdings of any specific past or current portfolio or account. The opinions expressed by Muzinich & Co. are as of November 2024, and may change without notice.

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Index descriptions

C1A0 - ICE BofA 1-3 Year US Corporate Index is a subset of ICE BofA US Corporate Index, including all securities with a remaining term to final maturity less than 3 years.

ER01 - The ICE BofA ML 1-3 Year Euro Corporate Index is a subset of ICE BofA ML Euro Corporate Index including all securities with a remaining term to maturity less than 3 years.

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