Is Now The Time to Step Out Of Cash?

Given the Federal Reserve’s March 2019 policy statement, which indicated a potential pause in the hiking cycle due to slowing growth, now may be the time to consider adding duration to bond portfolios.

April 05, 2019

Since the Federal Reserve dropped its target rate to 0-25 basis points in 2008, investors have been concerned with how rising rates could impact their bond portfolio, resulting in cash and cash-like investments growing near all-time highs. Given the Federal Reserve’s most recent policy statement in March 2019, indicating a pause in the hiking cycle and slowing global growth, now may be the time to consider adding duration to bond portfolios.

 

Short-term rates typically decline after the Fed rate hiking cycle ends

  • After the last rate hike, the Fed began cutting rates in three of four periods within 12 months and in all four periods within 15 months.
  • The Fed cut rates by an average of 119bps over the subsequent 12-months.

 

Fed Funds Rate Movement

12 months after last rate hike of each cycle

 

# of Months

Rate Cycle

Date of Final Rate Hike

Yield Change after 12 Months

Period 1 ('88-'89)

2/24/89

-150 bps

Period 2 ('94-'95)

2/1/95

-75 bps

Period 3 ('99-'00)

5/16/00

-250 bps

Period 4 ('04-'06)

6/29/06

0 bps

 

Average

-119 bps

Source: Bloomberg, Federal Reserve as of 12/31/18

Long-term rates also typically decline after the Fed rate hiking cycle ends

  • 10-Year U.S. Treasury Yields declined in the 12-months following the end of each of the past four rate hiking cycle periods.
  • The average 10-year Yield decline over the 12-months was 98 basis points.

 

10-Year U.S. Treasury Yield Movement

12 months after last rate hike of each cycle

 

# of Months

Rate Cycle

Date of Final Rate Hike

Yield Change after 12 Months

Period 1 ('88-'89)

2/24/89

-84 bps

Period 2 ('94-'95)

2/1/95

-208 bps

Period 3 ('99-'00)

5/16/00

-91 bps

Period 4 ('04-'06)

6/29/06

9 bps

 

Average

-98 bps

Source: Bloomberg, Federal Reserve as of 12/31/18

Stronger historical total returns vs. cash

From a total return perspective, stepping out of cash into either short or intermediate duration bonds has provided investors strong historical excess returns versus cash.

  • On average, short duration bonds have outperformed cash by over 2% per year over all time periods after the Fed’s last rate hike.
  • On average, intermediate duration bonds have outperformed cash by over 4% per year over all time periods after the Fed’s last rate hike.

Average annual % excess returns vs. cash (3m T-bill)

 

Average annual % excess return following final rate hike of each cycle

1-Year

2-Year

3-Year

4-Year

5-Year

Short Duration Bonds

+ 2.5

+ 2.26

+ 2.81

+ 2.63

+ 2.17

Intermediate Duration Bonds

+ 5.80

+ 4.18

+ 5.01

+ 4.98

+ 4.17

 

Source: Bloomberg, Federal Reserve, PGIM as of 12/31/18. Short Duratioin Bonds: BBG Barclays 1-3 Gov't/Credit Index. Intermediate Duration Bonds: BBG Barclays US Agg Bond Index.

 

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Definitions—Duration measures investment risk that takes into account both a bond’s interest payments and its value to maturity. Morningstar Short-Term Bond category contains funds that invest primarily in corporate and other investment-grade U.S. fixed income issues and typically have durations of 1.0 to 3.5 years. Morningstar Intermediate-Term Bond category average is comprised of portfolios that invest primarily in corporate and other investment-grade U.S. fixed income issues and have durations of 3.5 to 6.0 years. Bloomberg Barclays U.S. Government/ Credit 1–3 Year Index is an unmanaged index considered representative of the performance of short-term U.S. corporate bonds and U.S. government bonds with maturities from one to three years. Bloomberg Barclays U.S. Aggregate Bond Index covers the U.S. dollar-denominated, investment-grade, fixed rate, taxable bond market of Securities and Exchange Commission-registered securities. All indexes are unmanaged. An investment cannot be made directly in an index or an average.

Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed security backed by commercial mortgages rather than residential mortgages. They are composed of a variety of loans, each of which represents different property sizes and locations. These loans are pooled and are broken into tranches of risk that are sold to investors. High yield bonds, known as junk bonds, are subject to a high level of credit and market risk. International bonds are bonds issued by foreign corporations or foreign government agencies. Emerging market bonds are local currency bonds issued by emerging market governments. Emerging market countries may have unstable governments and/or economies that are subject to sudden changes. These changes may be magnified by the countries’ emergent financial markets, resulting in significant volatility to investments in these countries. Investment-grade corporate bonds are bonds with a credit rating of AAA to BBB as rated by Standard & Poor’s, or Aaa to Baa as rated by Moody’s. Mortgages refer to mortgage-backed securities (MBS), which are composed of a variety of residential mortgage loans, each of which represents different property sizes and locations. These loans are pooled and are broken into tranches of risk that are sold to investors. Collateralized loan obligations (CLOs) are securities backed by a pool of debt, often low-rated corporate loans. Municipal bonds are tax-exempt bonds with a maturity of at least one year, including state and local general obligation, revenue, insured, and pre-refunded bonds. Unlike other investment vehicles, U.S. government securities and U.S. Treasury bills are backed by the full faith and credit of the U.S. government, are less volatile than equity investments, and provide a guaranteed return of principal at maturity. Asset allocation and diversification do not assure a profit or protect against loss in declining markets. Past performance is no guarantee of future results.

 

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