The Case for Bonds Over Deposits
Figure 1: Fed pauses usually signal peaks in cash deposit rates
Source: Bloomberg, DBS
Bad news comes in pairs – high returns of cash is now at risk. Not only have concentration risks of cash deposits been made apparent, but so have return risks. Banking sector-related stresses have resurfaced narratives of monetary policy tightening having run its course, resulting in a massive 1.5% decline in the December Fed funds futures pricing since end-Feb 2023. Should this signal a pause in/the end of the Fed hike cycle, the days of high yields on cash deposits are certainly numbered, if history is any guide.
Figure 2: Cash never yields the same as IG credit for long
Source: Bloomberg, DBS
Cash or credit? This was the premise for our long-standing preference for quality credit over cash deposits, given that investors (a) can be well-diversified rather than have financial sector concentration risks, and (b) can lock in higher yields for a longer duration than the fleeting high rates of cash. The past 20 years illustrates this clearly; cash yields hardly ever come close to IG credit for more than a year. This means that investors are often better off taking a bit of duration risk in IG credit to lock in such high yields for a longer timeframe.
Moreover, high cash rates are not sustainable in a highly leveraged world; when cash and IG yields coincide, a recession generally ensues which forces rates lower again. Investors who hold only cash would merely see reinvestment risks with the decline in rates, while IG credit investors would experience capital gains as the rate environment adjusts lower, lifting bond prices.
Figure 3: Quality credit outperforms cash after the Fed takes a pause
Source: Bloomberg, DBS
Echoes of the past. This phenomenon of credit outperforming cash is clearly observed in the notable episodes of Fed pauses since 1987. In the six instances observed above, cash rates (approximated by the 3-month LIBOR) see a mean peak-to-trough yield decline of 3.5% over 2.4 years on average following a pause in the rate hike cycle – usually due to the emergence of some form of economic stress – implying that reinvestment risk runs high once the hiking cycle is over. IG Credit on the other hand, sees tailwinds take over from the lower rates environment, averaging an annualized yield of 10.6% in the same period.
Stay with quality short duration credit. Towards the end of 2022, we opined that there was going to be a narrowing window for higher yields of such quality credit, due to (a) the inverted yield curve, (b) moderating inflation, and (c) Fed policy rate projections. What was not consensus at the time is fast becoming apparent, with systemic stresses in the financial markets coming to the fore. We continue to recommend that investors capitalize on this narrowing window by shifting cash towards high quality credit – in what we termed the Liquid+ strategy – to capture yields while stocks last.
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