How To Manage Cash When Interest Rate Cuts Are Postponed?

The U.S. Federal Reserve (Fed) held interest rates steady on Wednesday 1st May 2024. This piece of news is important because Singapore effects monetary policy through its exchange rate, so our local interest rates tend to track US interest rates.

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For the 198th week of our #SundayTimesRecap series, let us take reference to this article published in yesterday's Sunday Times Invest Section, “Managing cash as interest rate cuts postponed”, and learn what these changes in interest rates are all about, why they are needed, and what it means for investors who are depending on interest rates for their cash holdings.

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The Fed lowers interest rates in order to stimulate economic growth, as lower financing costs can encourage borrowing and investing. However, when rates are too low, they can spur excessive growth and subsequent inflation, reducing purchasing power and undermining the sustainability of the economic expansion.

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On the other hand, when there is too much growth, the Fed raises interest rates in order to slow inflation and return growth to more sustainable levels. This was what happened back in March 2022, when the first increase in interest rates were effected, from 0.25% to 0.50%, followed by a series of increases until it reached 5.5% in July 2023 and it had been held steady since then until now.

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This is because, although increasing interest rates is a good tool to fight inflation, the Fed cannot raise interest rates too much and too fast, because it would mean higher borrowing costs, from which you can observe how Singapore homeowners are suffering heat of higher interest rates, when they have to pay higher monthly home loan repayment in recent times. Hence, the need to keep interest rates steady for now even though there was higher-than-expected US inflation earlier in the year.

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What are some decisions investors can make with regards to cash holdings, now that interest rates are kept steady in the near term?

1. Go for six-month T-bills or one-year T-bill? The latest six-month T-bill came in with a cut-off yield of 3.74%, which is higher than the cut-off yield of 3.58% for the one-year T-bill. However, the reinvestment risk is that if the Fed decides to lower short-term interest rates in the next six months, investors may not be able to reinvest the money in a T-bill at a similar or better yield. Therefore, if you have cash that you do not need to use in the next 12 months, you may want to consider investing in one-year T-bills to lock in the current yield.

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2. What to choose: fixed deposits, SSBs and T-bills? Spread the cash needed in the next five years using all three instruments: Fixed deposits, Singapore Savings Bonds (SSBs), as well as T-bills. For example,

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Cash needed for immediate drawdown can be in a savings account.

Cash needed in the next six to 12 months can be placed in T-bills.

Cash can also be placed in SSBs to lock in the yield, in case it drops.

Finally, another instrument to consider if investors need to park cash for the short term can be a short maturity single premium endowment. This is usually between one and three years in maturity.

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If more cash is needed in an emergency, a larger proportion of cash can be placed in fixed deposits as this gives immediate liquidity. The next higher proportion can be placed in SSBs and the rest in T-bills.

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However, if it is unlikely that cash will be needed at short notice, say for an emergency, more can be allocated to T-bills.

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Fixed deposit interest rates generally tend to track T-bills yield and have trended lower this year. Getting over 3% per cent is still possible, but the best rates are still lower than that for the T-bills.

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Given rates are expected to hover higher for a while more, there are other avenues apart from T-bills where investors can lock in the current interest rate.

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3. Bonds are also used as a source of income by investors, so how should they adjust their portfolio? As the Fed has not moved so far on rates, there is not much movement in bond yields and the short end of the curve (two years or less) provides a higher level of interest rates which immediately rewards investors. Investors can consider holding high-yield corporate debt. In this situation, the income component generates the bulk of total return.? Assuming the Fed does not make any changes until later this year, bonds yields will remain steady. That means there will not be much change in bond prices and income (interest) will be the main contributor to an investor’s total return.

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When the Fed signals its intention to cut rates – likely later this year – the lower bond yields will translate into higher bond prices and hence capital gain will make a larger contribution to total return.

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The default rate (of bonds) is likely to remain low for now, given the resilient growth. Current yields offer an entry point for investors.

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If you are investing for the long term, bonds or bond funds are a staple in the portfolio, as they act as a shock absorber to moderate the volatility of the portfolio so that investors can stay invested and reap the long-term rewards.

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There are several factors we would consider, including the credit quality of the underlying bonds held, the average duration of the bonds, as well as how diversified the fund may be.

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Investors looking to secure higher interest rates for the longer term – two years or more – can also consider new bond issuances. These bonds should be issued with higher coupon rates compared with those issued during low-interest periods.

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4. Real estate investment trusts (Reits) are often used by investors for their yield and potential capital gain as well as to access the realestate asset class. Since the Fed started to hike rates, Reits have struggled to find their footing. Analysts agree that rising interest rates pose challenges for Reits as they tend to decrease the value of properties and increase borrowing costs.

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While Reits usually offer attractive yields, current interest rate levels mean lower-risk bonds may offer attractive yields too and be an alternative to property trusts.

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Reits may continue to see a mixed performance if a rate cut does not happen, as each may be impacted by the elevated interest rates to varying degrees. Investors should look into the fundamental strength of the Reit, its balance sheet quality, as well as valuation to determine if the Reit may be worthwhile buying. Study the dividend yields and the opportunity cost relative to another investment option (for example a diversified index fund) to evaluate if the expected returns are worth the risk.

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If you wish to gain exposure to Reits without analysing individual counters, you can consider Reit exchange-traded funds (ETFs) to gain a broad-based exposure to the sector.

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Here’s the bottom line, to whatever approach you are taking in terms of your cash holdings: An investor’s portfolio should be positioned strategically for the long term and not make short-term tactical changes. This is because evidence has shown that investors who try to be tactical in the short term tend to do worse than the markets. The most sensible approach is to be invested in a globally diversified portfolio of equities and bonds in the proportion where it is suitable for investors’ ability and willingness to stay invested for the long haul.

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Therefore, given that rates have yet to fall, holding short-term six-month T-bills still looks like a good choice. But investors should also consider one-year and longer tenures for their investment instruments in view of the re-investment risk.

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With this foundation knowledge, I now invite you to join my next webinar, “The Lifetime Income Streams”, on Tuesday 21st May 2024 at 8pm, where my teammates and I will share more knowledge for you to embark on your investing journey. You can learn several lower risk investing strategies that can help you grow more than just interest.

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In fact, you can create assets which give you a monthly income for life, and you can still sleep well at night. You will feel more confident in managing your money matters as most of our attendees can testify.

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Register for the zoom link – select “Invited by Victor” - here: https://www.thelifetimeincomestreams.com/tlisvip.

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