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Falling interest rates will lower future returns on cash. Portfolio managers Tatjana Greil-Castro and Ian Horn explain how an allocation to short-duration corporate bonds could offer protection against this reinvestment risk without exposing investors to undue duration risk.
For investors in cash and short-term investments, higher interest rates from 2022 onwards led to a ‘dash for cash’ given the almost failsafe opportunity to generate decent nominal returns for little risk.
Interest rates now appear to have peaked, and, at the time of writing, two US rate cuts are predicted for the remainder of 2024. It is a similar story elsewhere: the European Central Bank (ECB) has already loosened monetary policy with a 25 basis points cut in June and more cuts are expected, while central banks in Canada, Sweden and Switzerland are also in easing mode.
Where to put your cash?
While rate cuts may be good for borrowers, they are less positive for savers or investors in cash deposits or very short-dated fixed income. These instruments face significant reinvestment risks when central banks cut interest rates, as the yield on those instruments can reset lower over a relatively short timeframe, with little or no capital gain benefit from the fall in yield.
The current market narrative stipulates interest rate curves will rally in response to central bank rate cuts. However, we believe the inverted rate curve indicates the market has already anticipated these cuts.
Therefore, central bank rate cuts could lead to a steepening in curves, not only by lower rates in the very short-end of the curve — driven by lower policy rates – but also by rates in the longer part of the curve moving higher. This would be supported by a recession-like environment being avoided; higher long-term inflation expectations — perhaps as a result of incoming political policies — and rate cuts stimulating economic activity and future growth prospects.
In any case, we expect there to be a wide range of possible outcomes in the longer-end of the curve in response to central bank rate cuts, resulting in a lower predictability of returns.
Current German Bund curve versus a normalised curve with ECB deposit rate of 2.5%
In the chart below we plot the current German Bund yield curve, as at June 30. We then compare this to a simulated yield curve with two key assumptions: (i) the ECB cuts its deposit rate to 2.5% over the next 24 months (as currently implied by the market); and (ii) the yield curve re-steepens with a difference of 100 basis points between the ECB rate and German 10-year Bund yield.
A similar exercise can be carried out for other yield curves including US Treasuries and UK Gilts, both of which also appear likely to re-steepen in the coming months, in our view.
Simulated performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy
Source: Muzinich & Co views and opinions, as of 30th June 2024. For illustrative purposes only and not to be construed as investment advice.
Short-dated corporate debt: A stepping stone to success?
enhancement and lower reinvestment risk, we believe there is a sweet-spot in short-dated credit, as shown above. Here there is the opportunity to participate in price increases as the short-end of the rate curve falls, whilst avoiding potential losses in the long-end as rate curves re-steepen.
An allocation into short-dated corporate credit offers limited duration risk and a potential spread premium over government bonds and cash instruments. For more conservative investors, an allocation into a pure investment-grade portfolio could be an option, while those with a higher risk appetite might consider a crossover strategy (combining investment grade and high yield) or a pure high-yield strategy.
“An allocation into short-dated corporate credit offers limited duration risk and a potential spread premium over government bonds and cash instruments.”
Ian Horn
This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of July 2024 and may change without notice.
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