- With interest rate cuts on the horizon, investors may want to consider moving away from overweight allocations in cash in favour of longer-term return opportunities available now in bonds.
- In our view, a broadly diversified global bond portfolio with a medium-term duration profile can provide the best of both worlds: an attractive balance of risk and return that can help mitigate downside risk while capturing upside in an uneven market environment.
- The periods after rates peak have historically been beneficial for bondholders, with bonds outperforming cash in each of the post-peak periods after the last six rate-hiking cycles by the Bank of England.
Many investors have preferred cash to bonds in recent years as they anticipated the interest rate hiking campaigns by central banks that began in 2022.
While holding cash has generally helped investors avoid the fluctuations in bond markets over the last few years, continuing to do so may wind up serving as an example of what worked in the past may not work so well in the future.
With rate hiking cycles now behind us, and rate cuts on the horizon in many markets, it's time for investors to reconsider their allocations to cash, while also taking stock of how their fixed income allocations are invested across maturities.
The cash-bond trade-off in the current market
With bonds, investors can take advantage of current high levels of income and yield while also positioning their portfolios to capture the capital gains from potential future rate cuts, which are likely to cause existing bond prices to increase.
Those who stay parked in cash could not only miss out on the potential price gains in bonds when rates eventually start falling, they'd also likely see their cash rate start to fall too, as cash rates tend to quickly reflect any changes in interest rates.
Shifting expectations in bond markets
Part of the appeal of cash has been its apparent relative stability compared to bond markets, which have endured heightened levels of volatility in recent years — including a significant selloff earlier this year.
This year's repricing came in the wake of last year's end-of-year bond rally, when expectations of rate cuts in early 2024 had pushed up bond prices—resulting in global bond markets posting their best two-month returns in November and December 2023 since the global financial crisis1.
In January, the rally reversed, as markets adjusted their interest rate outlooks to be more in line with Vanguard's long-held view that central banks in the UK and Europe are more likely to cut rates in the second half of 2024.
Despite the turbulence we've seen this year, it's worth remembering that rate cuts still remain on the horizon – just not at the pace and magnitude that bond markets had initially expected. Bonds are still offering high levels of income bolstered by potential total return tailwinds from future rate cuts.
Post-peak periods have benefitted bond investors
Sometimes, the past can help guide us on our way forward. If we apply that principle to rate hiking cycles, historically, we see a strong pattern of bonds outperforming cash in the periods after central banks stopped raising rates, as shown in the chart below:
Notes: The chart shows total returns in each of the years following the end of a rate hiking cycle for cash (UK Sterling 3-month deposit rate), gilts (Bloomberg Sterling Gilts Total Return Index), global bonds (Bloomberg Global Aggregate Index (GBP Hedged) and global equities (MSCI World Index (GBP Hedged)). All performance calculated in GBP with gross income reinvested. Source: Vanguard, based on data from Refinitiv, as at 30 September 2023.
In the UK, global bonds have outperformed cash in the periods after rates peaked in all of the last six rate hiking cycles by the Bank of England2 – offering greater protection for client portfolios when they needed it the most.
What if clients continue to prefer cash to bonds?
Because yield curves remain inverted, high rates on cash may make it tempting for clients to wait, but that's not a riskless decision. When central banks cut policy rates, cash rates tend to follow. Clients may miss the moment and face reinvesting at much lower rates than they could get now on bonds. Additionally, they could wind up missing out on future capital gains in longer-duration diversified bond portfolios, which often experience strong price rises when interest rates decline.
It's worth noting that even if cash has a higher starting yield than bonds, it doesn't guarantee cash will outperform, even in the near term. In 2023, for example, returns on global bonds beat cash returns, even though cash yields were higher than bond yields at certain points of the year3. This was because the price appreciation in bond markets in late 2023 boosted bonds' total returns above those on cash accounts.
Global bonds can offer a balance of risk and return in an uneven market
In a recent article, we explained why the inverted yield curve means traditional longer-dated government bonds may not currently offer attractive returns relative to the term risk involved.
In our view, a portfolio of global bonds offers an attractive balance of risk and return, with an intermediate-term duration profile that straddles the long and short ends of the yield curve — allowing them to perform in both rising and falling rate environments.
For example, the Bloomberg Global Aggregate Index has a duration of 6.9 years – meaning if rates suddenly rose by one percentage point, the index could see a ~6.9% price decline. However, with a yield of 4.0%4, the index's higher interest income component can help counter the fall in bond prices from such a move, leaving investors with an expected total loss of just 2.9%5.
Conversely, if interest rates were to fall by one percentage point, the portfolio would be poised to see gains of 10.9%—providing a healthy boost in total returns for bond portfolios6.
Global bonds can add to upside, help cushion downside
Notes: Proxies used: Short-term investment-grade bonds: Bloomberg GBP Non-Government 1-5 Year 200MM Float Adjusted Bond Index, which has an average duration of 2.6 years and a yield to maturity of 5.3%; Investment-grade (intermediate-term) bonds: Bloomberg GBP Non-Government Float Adjusted Bond Index, which has a duration of 5.5 years and a yield to maturity of 5.4%; Long duration gilts: Bloomberg U.K. Government 15+ Years Float Adjusted Bond Index, which has a duration of 16.6 years and a yield to maturity of 4.7%. Source: Bloomberg, with Vanguard calculations. Calculations in GBP, as at 31 May 2024.
Considerations for advisers
For most clients, it makes sense to consider moving away from overweight positions in cash towards a broad, high-quality bond exposure with a diversified allocation across the maturity spectrum.
Of course, it's always best practice to align a client's portfolio duration with their approximate investment horizon. For clients who plan to access their money within the next year or so, cash remains an appropriate option. But for those with longer time horizons, an allocation to high-quality, well-diversified fixed income can deliver strong risk-adjusted returns that can help your clients' meet their longer-term goals.
1 Source: Vanguard.
2 Source: Vanguard.
3 The Bloomberg Global Aggregate Bond Index (GBP Hedged) outperformed the Barclays Benchmark Overnight GBP Cash Index by 1.53% for the 12-month period from 31 December 2022 to 31 December 2023. Source: Vanguard and Bloomberg.
4 Source: Vanguard and Bloomberg, based on the Bloomberg Global Aggregate Index (GBP Hedged), as at 12 June 2024. ‘Yield' refers to the index's yield-to-worst, which is the lowest potential annualised return an investor can earn on the bond if held to maturity, when all possible option scenarios are considered.
5 Source: Vanguard and Bloomberg. Based on hypothetical interest rate and return scenarios for the Bloomberg Global Aggegrate Index (GBP Hedged), as at 12 June 2024. Calculations in GBP.
6 Source: Vanguard and Bloomberg. Based on hypothetical return scenarios for the Bloomberg Global Aggegrate Index (GBP Hedged), as at 12 June 2024. Calculations in GBP.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future results.
Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
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