On average, core plus bond portfolios (primarily investment-grade bonds with short or intermediate maturities of 10 years or less) outperformed cash – as gauged by three-month Treasury bills – by about five percentage points over the year following the peak in the Fed funds rate, and by about 4.5 percentage points annualised over the ensuing three years.
It doesn’t take much for bonds to outperform cash given their greater sensitivity to interest rate changes. A yield decline of only about 0.8 percentage points has the potential to generate price appreciation and lead to a portfolio of short and intermediate maturities doubling the return of cash (in line with the historical average).
Fed rate hike unlikely, but risks loom
Perhaps the only thing holding investors back from deploying that cash is the possibility that the Fed is forced to reverse course and raise rates. If this happens, the Fed funds rate would not have peaked yet.
Additionally, the yield curve would continue to invert – this is when long-term interest rates fall below short-term rates because investors expect the economy to slow down in the future. As a result, holding onto cash could provide an even greater benefit over investing in bonds.
However, we think this is unlikely. Recent growth and inflation data have been higher than expected, which might delay pending rate cuts, but we still believe the Fed is keen to start normalising monetary policy this year.
At the same time, yield curve inversions have not lasted long historically. We can identify 12 distinct inversions going back to the 1970s, each lasting about seven months on average. The current one has already endured for about two years.
An analogue for investors
In 2021, when bond yields first hit rock bottom, many savvy chief financial officers issued debt and termed out their liabilities, locking in historically low borrowing costs by issuing longer-dated debt.
Investors may want to apply a similar approach by locking in the current higher interest rates before the economic cycle changes again.
Cash rates are only guaranteed overnight and are set to fall when the Fed ultimately starts cutting rates. Terming out and locking in could be a savvy strategy for investors as well.
For a deeper analysis on moving money out of cash into bonds, read the original full version of the commentary here.
This article is written by PIMCO experts Marc P. Seidner, managing director and chief investment officer non-traditional strategies, and Pramol Dhawan, managing director and portfolio manager.