Time to get off the sidelines?

The volatile markets of the past few years caused many investors to, understandably, move money into a less volatile asset – cash.  Rising interest rates on the back of Central Bank's aggressive rate hikes in 2022 and 2023 rewarded investors for holding cash. Over US$1 trillion poured into money market funds globally in 2023, and the amount of cash held worldwide in money market funds sat at US$9.2 trillion to end the year, up 19% from 2022.¹

While cash has provided income temporarily during this tightening cycle, over the long-term, cash has not provided the same level of potential ballast and portfolio diversification against riskier assets such as equities.

Figure 1 highlights how quickly cash yields can fall, by looking at the 2001 rate cut cycle in Canada. Money market fund 12-month returns fell from 3.4% in December 2000 to 2.2% by June 2001 and down to 1.6% by December 2001 (Figure 1). Similarly, in the U.S., money market fund 12-month returns fell from 5.8% in March 2001 to 2.6% by March 2002 and down to 1.8% by July 2002.²

Figure 1 – Canadian money market one-year returns

Source: Morningstar, as of April 30, 2024. Based on forward 1-year returns. Money market fund returns represented by the Morningstar Canada Fund Canadian Money Market Category. Past performance does not guarantee or indicate future results.

As major developed market (DM) central banks begin to ease policy rates from decade highs, the time of elevated cash rates may ultimately be coming to an end. We believe this means investors may want to consider moving back to fixed income.

How to get back into bonds

Harnessing the power of bond ETFs

For investors considering bonds again, how could they implement their fixed income allocation?

1. Utilize a bond investing toolkit. There are many ways to invest in fixed income including: individual bonds themselves, mutual funds, closed-end funds, separately managed accounts, and bond ETFs. An investor’s specific circumstances, including investment objectives, holding period, tax position and investing platform (e.g., brokerage account vs. retirement account), can help determine the ultimate choice of exposure. 

2.  Adopt a portfolio mindset. The new yield landscape means that there are now many opportunities in fixed income for investors to pursue. In an effort to build durable, resilient portfolios, investors are now able to use low-cost index exposures at the core, while employing active strategies to seek enhanced returns. For example, index bond ETFs are liquid, transparent, and efficient, making them good building blocks for the core of a portfolio. At the same time, active bond ETFs can augment this portfolio by providing the potential for enhanced return and diversification of opportunities.

Investors who are calibrating their bond portfolios may be confronted with a range of macro environments going forward. Will central banks keep policy restrictive for too long and tip the economy into a hard landing and recession? Or will they actually “land the plane” in the idealistic soft-landing scenario?

We explore three macro scenarios below. We believe that in each of these scenarios, at least some movement out of cash and into longer maturities is warranted. We also consider different ETFs that investors may wish to explore depending on their market views.

Scenario 1: Central banks engineer a soft landing

In this ‘goldilocks’ scenario, we see falling inflation and central banks starting to gradually cut rates and re-steepen/normalize the yield curve to become upward sloping once again.

In this scenario, investors could consider balancing the belly of the curve with high-quality, longer-duration bonds and higher income asset classes. We look to duration exposures in a range of 3-7 years, which may offer a good trade-off between current yield and potential upside valuation gains as rates fall. Additionally, for investors seeking higher income, high yield credit and risk assets in general could become much more attractive with lower refinancing risk and positive economic growth helping to contain default risk.

Figure 2 – Scenario 1 related RBC iShares ETFs

_{Source: BlackRock; Data as of 8/31/2024.}

Scenario 2: Central banks cut rates given fears of recession

In a hard landing / recessionary scenario, both growth and inflation may recede rapidly, which may lead to a sudden decrease in policy rates. Such a scenario could harm risk assets and historically has triggered a flight to quality in which the longest maturity instruments should benefit from falling yields.

Investors may not want to abandon ballast just because short-term rates are higher. Cash likely will not provide the same potential ballast as bonds, so investors believing that such a scenario is more likely could consider at a minimum “barbelling” their current cash allocation with long duration instruments to help cushion risk assets and provide equity diversification. Investors may consider holding high quality assets like government bonds and higher quality credit exposures.

Figure 3 – Scenario 2 related RBC iShares ETFs

_{Source: BlackRock; Data as of 8/31/2024.}

Scenario 3: Central banks hike again

For those investors who believe that inflation will persist and that central banks will maintain or even enhance restrictive monetary policy – even at the cost of deteriorating economic growth – it may make sense to continue owning shorter maturity instruments (both nominal and inflation protected). This may help insulate investors from further increases in policy rates and stickier inflation.

With current inverted yield curves, where short-term interest rates are higher than long-term interest rates, we believe shorter-duration maturities could offer attractive yields versus cash and could support those seeking capital preservation. Like the prior scenario, investors may want to consider holding high quality assets like government bonds and higher quality credit exposures.

Figure 4 – Scenario 3 related RBC iShares ETFs

_{Source: BlackRock; Data as of 8/31/2024.}

Conclusion

We had a profoundly challenging period in global bond markets brought on by global inflation and resulting aggressive central bank tightening, causing many investors to move money into cash.  We believe now investors have a compelling case for moving off the sidelines and back into fixed income for the long-term. The granularity, efficiency, and versatility of fixed income ETFs make them an effective tool for fortifying portfolios with fixed income exposure. 

Authors

Stephen Laipply, Global Co-Head of iShares. Fixed Income ETFs

Karen Veraa, U.S. Head of iShares Fixed Income Product Strategy

Rachel Siu, BlackRock Canada Fixed Income Strategy

Hersi Shima, BlackRock Canada Fixed Income Strategy

Ross Pastman, BlackRock Canada Fixed Income Strategy

Pat Sproule, BlackRock Canada Fixed Income Strategy