- Investment Strategy Analyst
United Kingdom, Institutional
Change
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Cash with a roughly 5% yield is a beautiful thing. It’s been a boon to savers and acted as an offset to higher borrowing costs in mortgages, auto loans and credit cards. It’s also cushioned consumption, which accounts for two-thirds of the UK economy.
But while it’s easy to get attached to high-yielding cash, we see reason to believe it may be time to move into bonds. Looking at previous interest-rate hiking cycles, we find that holding cash while waiting until there’s more certainty about the economic outlook, the interest-rate path or the geopolitical environment could ultimately mean a lower total return relative to bonds.
We first analysed the three-year total returns of cash, global government bonds and global corporate bonds, starting from the last hike of each of the five full Bank of England (BOE) interest-rate tightening cycles since 1995. As shown in Figure 1, both government and corporate bonds outperformed cash.
Figure 1
We also tried giving cash an “advantage” by beginning our total return analysis from the first hike instead of the last one. We did this because of the possibility of a pause in the hiking cycle. That could mean a scenario where the BOE skips a meeting before hiking again if inflation persists above its target. Or it could be a longer period of policy inaction followed by the start of a new easing cycle. In either case, we wanted to see if bonds could outperform cash even after suffering drawdowns when the central bank was hiking rates. As shown in Figure 2, bond returns were similar to cash in the short term but ended up stronger over time.
Figure 2
Why was the experience in bonds superior to cash? We see three key reasons:
- Whether or not the investment horizon began with the first or last hike of each tightening cycle, it incorporated the next easing cycle, when the yield curve steepened as short-term rates fell.
- The market anticipated rate cuts in each tightening cycle three to 13 months before the next rate cut, adding positive returns in this period. Thus, an investor wanting to time the entry into bonds needed to be early. Our research showed that bond returns kept up with cash in the short term and eventually outperformed thanks to the ensuing easing cycle.
- Cash also tended to suffer during easing cycles as its yield dropped along with the central bank’s interest-rate cuts.
What are the risks? This cycle could be different. The inflation fight today is tougher than it has been in recent economic cycles, so the BOE may keep hiking rates or need to stay on hold for longer at these higher rate levels, so the yield on cash may stay higher for longer.
Investment implications
Assuming they are comfortable with the higher risk inherent in bonds versus cash, investors may want to consider moving out of cash and into longer maturities sooner rather than later. Even though some bonds currently have lower yields than cash, they've benefited materially more than cash in the past five BOE rate-hiking cycles on average. Since the market typically anticipates the next easing cycle, much of the positive return may accrue around the time of the last hike.
Corporate bonds have a better average return profile than government bonds and cash. Because corporate bonds have higher yields and spread-tightening potential, they've tended to outperform other fixed income sectors over a longer period.
An incremental step out of cash into bonds may not be as big a risk as one might expect. Even if the central bank keeps hiking, our analysis indicates that bond returns would be comparable to cash in the short term, and bonds would outperform longer term based on past cycles.
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