Exploring Alternatives to Cash During Uncertain Times

Exploring Alternatives to Cash During Uncertain Times

When central banks started their latest hiking cycle, it created a significant amount of uncertainty in the markets. Such uncertainty was amplified by high inflation, leading to higher volatility and underperformance across all asset classes, except for cash. As a result, a sense of caution likely compelled investors to allocate a large portion of their portfolio to cash.

However, it is important to consider whether sitting in cash is truly the best decision, especially when central banks begin lowering short-term interest rates. Investors cannot lock in current cash rates for extended periods of time, so exploring alternatives such as international fixed income with currency hedging can provide the potential for additional yield, diversification, and positive returns even in challenging market conditions.

The evolving yield curve

Although nominal yield curves became inverted after the hiking cycles in both the U.S. and Brazil (see Figure 1), the market is pricing in an eventual normalization.

Figure 1: Current yields and forward rates in U.S. and Brazil

As of 31 January 2024. SOURCE: Bloomberg, PIMCO. 1Y and 5Y horizon assume forward rates are realized. For illustrative purposes only.

The yield curve represents the yield of each maturity of government bonds. When the yield curve is inverted, it means that short-term bonds are paying higher yields than longer-term bonds. This phenomenon typically occurs in the middle and toward the end of a hiking cycle. However, once the hiking cycle ends, the curve could normalize faster than many investors realize. As the yield curve normalizes, yields on short-term bonds may decrease rapidly, decreasing the expected return for cash.

The opportunity cost of cash

When the yield curve is inverted, investors often allocate a significant portion of their portfolio to short-term bonds for three reasons. First, the trajectory of bond prices during a hiking cycle can be painful, and investors may have experienced a negative repricing of their longer-term bonds when the curve inverted. Second, there is usually a great deal of uncertainty, leading to higher-than-normal volatility in long-term bond yields. Third, higher short-term yields naturally allow investors to earn a higher yield – at least in the short term.

However, it is important to consider the consequences once the yield curve normalizes. Investors who solely invest in short-term bonds will likely reinvest at lower yields and miss the opportunity to lock in attractive yields for longer.

In the case of Brazilian investors, they have the option to invest in securities that pay the one-day interest rate, CDI, with zero duration risk. This may seem appealing when the CDI is yielding double-digit returns. However, it is crucial to understand that this investment does not lock in the high return for the long term. For example, if an investor bought a security on 25 Mar 2024 that pays CDI and holds it for a year, they would receive 10.65%, assuming the central bank does not change interest rates. However, if the central bank cuts interest rates during the year, the investor would receive a lower rate. Currently, the market expects a one-year investment in CDI to return 9.75% rather than 11.65%.

Diversification: exploring international fixed income

Brazilian investors can invest in international fixed income with a currency hedge, adding yield potential and diversification to their portfolios. Historically, the interest rate differential between Brazil and the U.S. has been positive, averaging above 6% since 2011. This interest rate differential represents the additional yield that Brazilian investors receive on top of the international investment when the currency hedge is in place (see Figure 2). Although the current differential is lower due to high U.S. rates, it is expected to normalize back to the average over the next few years (assuming today’s forward rates realize) as yield curves return to their more typical upward slope.

Figure 2: Interest rate differential between U.S. and Brazil highlights opportunities in international diversification

As of 31 January 2024. Source: PIMCO. For illustrative purposes only. Figure is not indicative of the past or future results of any PIMCO product or strategy. There is no assurance that the stated results will be achieved.

¹   The carry differential is the annualized 3M forward discount rate of BRL against USD (positive if forward BRL is cheaper than spot).The forecasted carry differential is defined as the annualized 3M cash rate differential between Brazil and the US implied by each yield curve scenario plus a cross-currency basis that follows a mean-reverting AR(1) process estimated from historical data.

“Rates stayed anchored longer" scenario assumes interest rate shocks occur at 0.5x the magnitude implied by forward curves. “Rates normalize faster” scenario assumes interest rate shocks occur at 1.5x the magnitude implied by forward curves.

Diversification is another advantage of investing in international fixed income, which historically has had a very low correlation to Brazilian assets, providing additional risk mitigation. Moreover, investors often reallocate to international fixed income during moments of market stress – meaning fixed income has tended to yield positive returns when risk assets are underperforming.

Stress testing the next 12 months

In a diversified portfolio of international fixed income assets, there are three main drivers of return: carry, movements in rates, and movements in spread.

Carry is mainly determined by the yield of the portfolio. To analyze potential outcomes, we conducted a scenario analysis to assess the impact of rate and spread movements on the average multi-sector fixed income fund in Morningstar, assuming Brazilian investors hedge any currency exposure.

For rate movements, we stress the 10-year U.S. Treasury rate in five different scenarios, ranging from a fall of 100 basis points to a rise of 100 basis points (see Figure 3). For spread movements, the U.S. high yield spread is stressed from a 150-basis-point tightening to a 300-basis-point widening. It is important to note that the current U.S. 10-year Treasury yield is ranked at the 95th percentile (based on 10 years of historical data), and a further increase of 100 basis points would represent a level above the 100th percentile. Similarly, the current high yield spread levels are roughly at the 21st percentile, and a further widening of 300 basis points would represent a 94th percentile level. We considered a wide range of scenarios that could occur over the next 12 months to ensure a comprehensive analysis.

Based on the analysis of 50 different scenarios, a portfolio investing in FX-hedged international fixed income would result in a return above 9.75% in 60% of the cases over a 12-month period. This means that in 60% of the scenarios, the investment in FX-hedged international fixed income would outperform the expected return of a one-year investment in CDI. Importantly, only one of the analyzed scenarios results in a negative return.

Figure 3: Stress testing an FX-hedged internationally diversified portfolio¹ – potential outcomes

As of 31 January 2024. Source: PIMCO, Morningstar. For illustrative purposes only. Figure is not indicative of the past or future results of any PIMCO product or strategy. There is no assurance that the stated results will be achieved. Estimated 12-month return by fixed income sector under different yield shocks 1 Multisector: Morningstar Multisector Bond Category. Estimated total return over the next year if risk factor shocks were to happen today. Analysis includes current portfolio carry for one year plus returns from simulated risk factor shocks. Does not consider changing positioning of managers/indices; risk factors are held constant. FX-hedge return corresponds to rolling 3-month forwards. Shocks are propagated to other risk factors (e.g., spread sectors are positive contributors when rates rise). No representation is being made that these scenarios are likely to occur or that any portfolio is likely to achieve profits, losses, or results similar to those shown. The scenario does not represent all possible outcomes and the analysis does not take into account all aspects of risk.

Overall, it is crucial for investors to carefully consider their investment options when cycles turn. While cash may seem like a safe choice, it may not be the best decision in the long run. Exploring alternatives such as international fixed income with currency hedging can provide the potential for additional yield, diversification, and positive returns even in challenging market conditions.