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Preparing for the Pivot: why now may be the time to move cash off the sidelines

Higher bond yields and improved total return potential may offer advisors a compelling opportunity to move cash off the sidelines.

Madvisors who moved into cash last year as interest rates rose sharply are asking: When is it time to get back in to longer-term fixed income investments and how?

The outlook for fixed income appears compelling after last year’s sell-off, which was spurred by US Fed (“Fed”) and other central bank interest rate hikes. Starting yields across most fixed income sectors are the highest in more than a decade. Since yield has tended to be a powerful indicator of forward returns, PIMCO’s five-year return expectation for the Bloomberg US Aggregate Index is 4.5% and our expectation for the FTSE Canada Universe Bond Index more than doubled to 3.7% in December 2022 from 1.7% in December 2021. Higher yields also potentially provide a stronger cushion against further rate hikes or spread widening, offering more attractive downside protection than a year ago.

Bonds are back

The question on most advisors’ minds focuses then on timing. Is it best to wait for the Fed to pause rate hikes before stepping out of cash? Figure 1 shows US core fixed income performance relative to cash over the last seven US Fed rate-hiking cycles since 1980. Over the typical 19-month cycle, rates initially rise and core fixed income underperforms cash, as happened in 2022 when the Fed began aggressively raising rates.

However, before the Fed reaches its peak policy rate (i.e., before it pauses or cuts), intermediate yields begin to fall on average and core fixed income allocations start to meaningfully outperform cash. While cash can mitigate downside risk as markets anticipate future rate hikes, the time to step out of cash typically comes as the Fed approaches its peak policy rate. At the time of this publication, we believe the Fed may soon pause its hikes as it evaluates the path of inflation.

Figure 1: This chart shows the relative performance of the Morningstar Core-Plus Bond Category and 3-month Treasury bills on average over the last seven fed hiking cycles dating back to the early 1980s. It illustrates that average 1-year forward returns for core bonds started to outpace cash about four months before the Fed reached its peak policy rate.

In evaluating the trade-off between US T-bills and other options within fixed income, it’s important to note that core bonds and the Morningstar short-term category (US) have consistently outperformed cash over periods of three years or more, the minimum horizon of most clients’ long-term investments. Figure 2 shows that core bonds have beaten cash 91% of the time over rolling three-year periods since 1978, with an average outperformance of 2.9 percentage points. Similarly, strategies in the Morningstar short-term category (US) have also demonstrated outperformance over most periods. Therefore, for most investors with reasonably long investment horizons, elevated cash allocations should be considered a short-term decision given the expected long-term advantages of remaining invested in high quality fixed income, in our view.

Figure 2: This chart shows the rolling three-year returns of the Bloomberg US Aggregate Index, 3- month Treasury bills and the Morningstar Short-Term Category. In 91% of the 3-year periods, the US Aggregate outperformed T-bills by 2.9% on average annually. In 78% of the 3-year periods, the Morningstar Short-Term Category outperformed T-bills 78% of the time by an annual 1.2% on average.

Looking ahead

With today’s inverted yield curve, many advisors have increased allocations to cash and short-term strategies within their fixed income portfolios. While this was an effective strategy in 2022, it’s important to consider the improved risk and return profile of fixed income strategies given today’s higher yields and the potential for an economic slowdown.

PIMCO offers tools to help advisors navigate the investment and behavioral challenges of fixed income investing in the current environment:

  • PIMCO Pro’s proprietary analytics allow advisors to drill into portfolio volatility by risk factor, stress test portfolios, and keep apprised of rapidly moving markets.
  • Our solutions team and PIMCO Pro specialists can create customized, deep-dive portfolio reviews that help advisors understand performance drivers across fixed income, equities and alternatives.
  • PIMCO Managed Bond Pools deliver a tactical, diversified and global fixed income solution in one ticket.
The Author

Justin Blesy

Asset Allocation Strategist

Brian Kyle

Global Wealth Management

Wade Sias

Strategist

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