Is it time to reallocate cash to bonds?

Anthony Wu, CFA, Portfolio Manager, SLGI Asset Management Inc.

From “cash is trash” to “cash is king”

For over two years since the beginning of the interest-rate-hiking cycle in 2022, cash has been a strong contender to bonds. After cash being undesirable for many years, it reclaimed its title as king in 2023. This was when bonds took a hit from high interest rates, and investors took shelter in cash because it offered safety and it comparatively high yields.

But can cash maintain its advantage over bonds in the coming quarters? We don’t think so.

We say this because the developed world’s central banks have pivoted to an interest-rate-cutting cycle as inflation concerns have eased and growth concerns have emerged. When that happens, longer-term bond yield falls faster than shorter-term bonds, offering capital appreciation opportunity in bonds.

Cash advantage fades

When short-term interest rates peaked in August 2023, the U.S. yield curve was inverted. This meant that the yield on shorter-term instruments maturing in less than two years was about 5% compared to longer-term 10-year bonds that yielded only 4%. That meant locking your cash for two years would comfortably yield at least one percentage point higher over long-term bonds.

Now that short-term interest rates are about to be cut in the U.S., short-term instruments and cash are losing their appeal. In fact, the yield advantage to investing in shorter-term two-year instruments over longer 10-year bonds almost completely evaporated as of August 2024. Furthermore, if growth concerns pick up later this year, cash yields are likely to be lower than today’s levels.

Bonds are back in favour

Longer-term bonds help lock the yield advantage for longer periods and reduce reinvestment risk. They also offer other benefits over cash. For one, bond prices typically appreciate as interest rate cut expectations rise. In about eight instances of interest rate cut cycles since the late 1980s, bonds prices aggressively gained about 60 days prior to the first rate cut. We see this now as the U.S. Federal Reserve prepares to begin its interest rate cutting cycle in September 2024. Secondly, in an environment of falling inflation, bonds can help diversify portfolios and act as a cushion in case equities turn volatile.

Bonds begin to rally a few months before rate cuts begin

Source: Bloomberg US Agg Total Return Value Unhedged USD Index

We think it’s time to reallocate some cash to longer-term bonds to both enhance return and to diversify.? ?

Within Granite, we believe it’s time to allocate to traditional bonds once again. We see the cutting cycle as a tailwind to bonds. A potential growth slowdown in the next six months could favour this asset class over cash.

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? SLGI Asset Management Inc. and its licensors, 2024. SLGI Asset Management Inc. is a member of the Sun Life group of companies. All rights reserved.