In our view, markets today may offer an attractive entry point for these five fixed income strategies. Which option might work for you?
When U.S. inflation data came in better than expected in early July, it may have signaled that the fastest rate hiking cycle in 40 years was nearing its end. But as markets anticipated, the Federal Reserve (Fed) raised interest rates by a quarter percentage point in late July, and we think it will now hold steady. Other developed market central banks are not far behind: The European Central Bank (ECB) and the Bank of England, which also raised rates in recent weeks, may hike just two more times this cycle. Rates globally are likely to fall in 2024.
If you are holding too much cash, the implications are clear: Today’s attractive cash yields may not last. When you reinvest, we believe it will be at lower rates.
That can make the current market juncture a good entry point to invest your surplus cash (held in bank deposits or short-term government bills, for example) in a range of high-quality investment strategies. These include:
- Money market funds—for a potential yield boost with daily liquidity
- Government bonds—for a potential yield pickup and limited credit risk
- Short-duration corporate bonds—for a potentially significant increase in yield with low credit and duration risk
- Long-duration corporate bonds—for potential yield, capital gains and portfolio diversification
- Private credit—for potentially very attractive yield (with targeted investments for opportunistic cash)
From this range of strategies, we believe investors can find the right approach to meet their liquidity needs, yield targets and risk tolerances.
The lesson of past hiking cycles
No one knows precisely when the Fed and other central banks will end their hiking cycles, or what their terminal rates (the rates that prevail at cycle’s end) will be. But from that point, cash will typically underperform other investments.
Consider: Over the last seven Fed hiking cycles, fixed income has outperformed cash by an average of 14% cumulatively in the two years following the final interest rate increase. And fixed income has never underperformed cash during that period.
History suggest that more duration tends to lead to higher outperformance after Fed hiking cycles
This graph shows the percentage of average total returns of U.S. treasuries by duration from final Fed hike over the last seven hiking cycles since 1981. The percentage is shown on the Y axis and months from final hike in the X axis. In terms of the performance on the graph, we see the following results: treasuries of 15+ years rises to 36% over the 23 months of fed hikes, treasuries of 10-15 years rises to 33% over 23 months, treasuries of 7-10 years rises to 30% over the 23 months of fed hikes, treasuries of 5-7 years rises to 28% over the 23 months of fed hikes, treasuries of 3-5 years rises to 25% over the 23 months of fed hikes, 3m T-bills rise to 25% over the 23 months of fed hikes.
Given the potential for history to repeat itself, which alternative to cash might be right for you now?
1. Money market funds
Money market funds (MMFs) are highly regulated portfolios of money market instruments, including commercial paper and bank certificates of deposit.
Taking modest and highly diversified interest rate and credit risk, MMFs offer higher yields than cash while still maintaining daily liquidity. For example, at the end of June, the JPMorgan Liquidity Funds offered a yield of 5.26% in USD, 3.27% in Euros and 4.71% in GBP.
2. Government bonds
Current bond market pricing tells us that investors expect the U.S. policy rate to peak at close to 5.5%, with the ECB deposit rate reaching a high of 3.7% and the U.K. bank rate topping out at 6.0% by the end of 2023.
That expectation, which we share, reflects the fact that inflation has cooled, allowing central banks to avoid making more significant rate hikes in an effort to bring prices under control. Rate hikes of the past 18 months have had their intended effects, making credit harder to come by. Real (after-inflation) yields are now positive for the first time in many years.
Global real yields look more attractive than they have in 15 years
This graph shows the global real yield as a percentage during a time period of 14 years from 1998 to 2022. We see a sharp descent from 3.5% in 1998 down to -1% in 2013, which stays roughly constant until dropping again to -2% in 2022 before rising sharply back up to almost 2% at the end of 2022.
In light of today’s market pricing—2-year U.K. Gilt yields at nearly 5% or 10-year inflation-protected U.S. Treasury yields above 1.5%—we believe government bonds could prove to be an especially attractive alternative to cash. In addition, investing in government bonds in some jurisdictions may provide certain tax advantages, depending on whether the coupon, yield or the capital gain or loss are treated at different rates.
3. Short-duration corporate bonds
Short-duration investment grade bonds, with maturities of one to three years, offer both income and total return (income plus potential capital gain). Indeed, we think short-duration investment grade bonds may deliver some of the most reliable risk-adjusted returns in any financial market over the next 12 to 24 months. They are likely to far exceed cash returns.
Investment grade (IG) corporate bonds with three-year maturities typically pay about 100 basis points (one percentage point) over equivalent cash yields and—this is key—IG bonds come with modest credit risk. Between 1920 and 2020, the average default rate of investment grade bonds was just 0.14% according to Moody’s Investor Services.
We anticipate default rates will remain quite manageable in the next downturn, in part because corporate balance sheets are in much better shape than they were in past cycles.
Market pricing sometimes underestimates that balance-sheet strength. Today, IG spreads (their excess yield over government bonds of a comparable maturity) are trading at or above their long-term averages, particularly in Europe. In other words, investors are demanding the extra yield over the “riskless” government bond.
Importantly, our preference for IG bonds does not extend to high yield credit. As economic growth slows and the economy approaches a downturn, we expect growing stresses, and higher default rates, for high yield credits.
4. Long-duration corporate bonds
Along with a yield pickup over cash, long-duration investment grade bonds can stand to deliver capital gains (and higher total return) if rates decline in a slowing economy. When rates fall, bond prices rise—and they rise proportionately more for the longer-dated bonds.
Because the Fed is the central bank closest to the end of its hiking cycle, we see the greatest potential for rate declines—and thus long duration price gains—in the U.S. markets. Given the ongoing inflationary pressures in the euro area economy, we expect the ECB will cut rates three to six months after the Fed. As a result, we anticipate less impressive returns for the European as opposed to the U.S. long- duration bonds over the coming year—though we still believe long-duration EUR bonds should outperform cash.
Finally, across global markets, long bonds offer the potential for portfolio diversification. If, as typically occurs, weaker (or negative) growth pressures corporate profits, driving stock prices lower, bonds will likely rally, mitigating the negative effects of lower equity values. Higher-than-expected inflation could erode that bond advantage, but we think inflation is well past its peak for this cycle.
5: Private credit
Unlike other fixed-income strategies, private credit can provide a good vehicle for your opportunistic (versus your surplus) cash.
Much of the private credit sector involves direct lending to businesses. As regulation and other factors have made it more difficult for traditional banks to lend to smaller and midsized businesses, private credit funds have stepped in to serve as “lenders of opportunity,” as they are known in the industry. Other private credit funds target special situations and distressed investment opportunities.
To business borrowers, private credit lenders can offer speed, flexibility and certainty of capital (the payroll will be met). Private credit lenders can charge relatively high rates on their loans, which in turn provides high yields to private credit fund investors. Yields on new loans can run around 10%, a very attractive level and a premium to public market fixed income yields.
But while today’s high yields are enticing, rising debt service costs may increase risks that borrowers will default on their loans and negatively impact private credit fund returns. We do expect default rates to increase in the next recession. That’s one reason you’ll want to partner with a private credit manager who can effectively and prudently source, evaluate and underwrite loans.
We can help
As cash yields look poised to fall, you may want to deploy your cash in one or more strategies. Your J.P. Morgan team can help you craft an approach that best suits your family’s long-term goals.
