Time to move out of cash and short duration fixed-income strategies?

A new phase for fixed-income assets

Fixed-income markets withstood an extraordinary 12 months that saw both record inflation and historic monetary policy. With 2022 firmly in the rearview mirror, inflation trending lower, and the U.S. Federal Reserve (Fed) likely nearing the end of the current rate-hiking cycle, we’re entering a new phase of fixed-income markets—one that’s accompanied by a risk factor that largely went under the radar while interest rates were on the rise: reinvestment risk.

Cash is an asset class … for now

Investors were right to be concerned about market volatility and elevated inflation in the past year and those who shifted into cash or short duration strategies early were rewarded as they were relatively well protected from the pressure of rising interest rates. Shorter duration strategies typically outperform in such an environment because they maintain less price sensitivity to higher yields.

As the Fed embarked on its rate-hiking path in March 2022, short-term yields became increasingly appealing to investors and those who preferred to stay in cash or other short duration products were able to capture attractive yields; however, as we near the end of the Fed’s rate-hiking cycle, investors should consider the potential impact of staying in cash or short duration strategies.

"As we transition to a stable or lower-rate environment, intermediate duration can be beneficial in maintaining these historic yield levels for an extended period." 

The reemergence of reinvestment risk

Now that we’re in an environment where interest rates could soon start to move lower, reinvestment risk has reemerged as a much more prevalent risk factor for fixed-income investors.

This is particularly relevant to investors who are looking to reinvest proceeds they’ve received from existing investments as they’ll need to be reinvested at current market yields, which tend to be lower in a falling interest-rate environment. This is also likely to affect investors who have moved into shorter duration strategies over the past year since these strategies will have to reinvest proceeds frequently as securities mature.

If inflation continues to trend lower, the Fed can be expected to shift away from rate-hiking mode. Should this happen, investors who have stayed in cash or short duration strategies will probably need to reassess their investment approach or face reinvesting at increasingly lower yields. 

"While the Fed typically pauses before it begins to cut rates, fixed-income markets don’t."

Capturing opportunities during the transition

As we transition to a stable or lower-rate environment, we believe intermediate duration can be beneficial in maintaining these historic yield levels for an extended period. Yield to maturity is a standard metric that estimates the annual rate of return an investor can expect to achieve on a fixed-income security until it matures. 

The average maturity of intermediate duration strategies is considerably longer than the average maturity found in short duration products, thereby enabling investors to lock in current higher yield levels for a longer period. In our view, this approach provides investors with an opportunity to preserve yields and allows them to capture any upside potential should the rate environment change.

Source: Bloomberg, Manulife Investment Management, as of 5/18/23. LHS refers to left-hand side. RHS refers to right-hand side. See index definitions in the disclosure section. It is not possible to invest directly in an index. 

As markets price in the end to the current rate-hiking cycle, we can look back to previous cycles to understand how yields responded in prior environments. When reviewing the prior four cycles—all with their own unique circumstances—it’s clear to us that the Fed rarely pivots immediately from hiking to cutting short-term interest rates. While the Fed typically pauses before it begins to cut rates, fixed-income markets don’t.

In fact, looking to those same four cycles, the 10-year U.S. Treasury yield declined, on average, by more than 100 basis points (bps) in the period between the Fed’s last rate hike of the prior interest-rate cycle and the first rate cut of the subsequent one. During that time, intermediate duration consistently outperformed short duration, benefiting not only from yield but also price appreciation due to the higher price sensitivity to changes in interest rates.

Source: Bloomberg, Manulife Investment Management, as of 5/18/23. Fed refers to the U.S. Federal Reserve. Bps refers to basis points. See index definitions in the disclosure section. It is not possible to invest directly in an index. 

Ladders may not get you to the top

There’s plenty of evidence that supports a transition to intermediate duration fixed income in the current market environment. Intermediate fixed income may appear attractive, but the way investors access these strategies remains critical and not all approaches are the same.

A popular solution for investors is to construct bond ladders, which involves building a portfolio of bonds with evenly spaced maturity dates that stretch over many years. Although ladders can provide some level of protection against interest-rate volatility, they’re less effective in managing reinvestment risk. They can also open investors up to greater idiosyncratic risk, particularly in the corporate credit space, as they tend to maintain more concentrated positions in a select group of corporate issuers.

Active management: the time is now

In our view, an actively managed total return approach is a more effective way for investors to gain exposure to intermediate duration bonds and take advantage of the current yield opportunity. Through active management, fixed-income investors can gain much more diversified exposure across a wide range of sectors and instruments, including those that could be difficult to include laddered portfolios. 

As markets shift from a rising interest-rate environment to one defined by stable or falling interest rates, so too should investors’ appetite for duration. In our view, investors can continue to capture the current historic yield levels for an extended period by moving out of cash and other short-term investments and into intermediate duration.

An actively managed total return approach, we believe, is the most effective method for gaining intermediate fixed-income exposure that allows investors to manage reinvestment risk, maintain yield, and participate in the relative value opportunities that can emerge in the midst of a more volatile market.