Risks and Opportunities: Moving from Cash to Bonds
Text on screen: PIMCO
Text on screen: FULL PAGE TITLE GRAPHIC: PIMCO EDUCATION, Risks and Opportunities: Moving from Cash to Bonds, with John Nersesian, (8 minutes)
Thank you for joining us today on this very timely topic around cash investments
Text on screen: John Nersesian, HEAD OF ADVISOR EDUCATION
and helping our clients overcome certain objections to moving out of cash and redeploying their capital in a potentially more productive manner.
Text on screen: TITLE – Cash on the Sidelines; SUBTITLE – Short-term yields have risen dramatically; Movement in rates (Q1 2000 – Q4 2023)
Image on screen: The figure displays a line graph showing short-term yields over the time period first quarter 2000 to fourth quarter 2003. Yields on three-month Treasuries and the U.S. Federal Funds Target Rate rise and fall in tandem over time. In 2023, yields for metrics are about 5.7%, near their peak on the chart of about 6.5% in 2000 and 2001. The chart shows how rates have risen dramatically from near zero in early 2022.
We know that interest rates have risen rather dramatically more than 10 increases by the Federal Reserve Board on the Fed funds rate, taking us to a level close to 5% and of course, that rather significant increase in interest rates has encouraged many clients to
Text on screen: TITLE – Cash on the Sidelines; SUBTITLE – Rise in cash balances; Substantial growth in money market funds (2003-2023)
Image on screen: The figure displays a graph showing the growth in cash balances in money market funds from 2003 to 2023. In 2023, the balances are at a high on the chart, nearing $6 trillion, up sharply since 2022, when balances were around $5 trillion.
reallocate capital towards shorter term investment options. Look at the balances in money market funds today, approaching $6 trillion.
Now, there are a variety of reasons as to why clients may want to hold a larger than normal cash position, let's review them.
Text on screen: TITLE – Reasons to hold cash
Image on screen: The slide gives five reasons to hold cash. The first reason notes that cash provides financial security and flexibility for current expenditures. Another advantage is to cover emergencies or unexpected expenses. Immunization against liabilities marks a third benefit. Holding cash also protect against market fluctuations, and it gives tactical opportunities to invest. Each of the five reasons contains further description on the slide.
Number one, it provides us with the opportunity to pay current bills and meet current expenditures.
Number two, it allows us to cover emergencies that are maybe unforeseen without having to liquidate assets at less attractive prices. It allows us to immunize certain known liabilities such as college tuition expenses with a greater degree of certainty, it can help us protect against market fluctuations when risk assets are exhibiting significant volatility and then some investors will maintain a larger than normal cash balance as a way of engaging in tactical opportunities to redeploy capital when the opportunities are greater and to reduce their risk exposures when opportunities are less attractive.
Here's one of the objections that we often hear from clients.
Text on screen: TITLE – Overcoming objections
Image on screen: The slide displays an objection to investing in bonds given by investors. The statement is highlighted in large text centered in the graphic, and reads as follows: “I think rates are going to continue to go up. I’ll wait until rates stop rising before I invest in bonds again.” An icon showing a quotation mark is situated above the statement.
John, I think interest rates are going to continue to go up, I'm going to wait until interest rates stop rising, before I invest in a variety of asset classes.
Well, let's take a look at the evidence before us. We've seen a significant increase,
Text on screen: TITLE –Treasury bill yields show slowing momentum
Image on screen: A line graph charts the path of the three-month U.S. Treasury bill and 10-year note, from October 2018 to January 2024. In October 2023, the three-month T-bill has a yield in excess of 5.5%, above that of the 10-year, whose yield is about 4.8%. The chart shows how the three-month yield starts rising from about zero around January 2022, then sharply ascending in the second quarter 2022 to about 4% in October 2022, then continuing at a less steep trajectory to its October 2023 high. The trajectory is almost flat in the third quarter of 2023. The graph also shows the 10-year rising from a low of less than 1% in the third quarter 2020. It rises gradually until it hits 2% in early 2022, then accelerates to 4% by around October 2022, before fluctuating between 3.5% and 4% until about July 2023, then breaking above that to its peak of about 4.8% around October 2023. Also, the graph shows how the three-month Treasury yield surpassing the 10-year around October 2022, and staying above it afterwards.
not only in short-term rates, but even in longer duration assets as well and the recent evidence suggests that we may be closer to the end of the cycle than we are at the beginning.
With that as a potential occurrence, how should investors think about the probabilities of different financial outcomes given this potential change in cycle?
Text on screen: TITLE – As hiking cycles end – a reversal in fixed income returns has tended to follow
Image on screen: A bar chart shows the range of fixed income performance over time, from 24 months before the peak of a hiking cycle, out to 24 months after the peak. Along the horizontal axis of the chart, bars show intervals of every four months. Green bars show positive performance above the line, and red bars show negative returns, pointing downward from the X-axis. Starting on the left, 24 months before the peak, the one-year forward excess return is about 3%. But from 20 months to eight months before the peak of the hiking cycle, the forward excess return is negative. It’s about negative-3.2% 16 months before the peak and negative-3% 12 months before. Yet by four months before the peak, excess forward return turns positive again, at about 2.5%, rising to about 4.5% 12 months after the peak. A table below the bar chart shoes the cumulative total return for the average advisor over time. Average advisor cumulative return is 3.1% 12 months before the peak, compared with 6.5% for the Citigroup Three-Month Treasury Bill Index. Yet by 12 months after the peak, average advisor cumulative performance is 9.4%, compared with 7.2% with the index. By three years after the peak, cumulative performance for the average advisor is 29.1%, compared with 17.4% for the index.
Well, we know that short-term cash investments produce a greater return than longer duration assets, as the Fed is engaged in this hiking cycle, but look at how that pivot returns, once the Fed is done raising interest rates.
Text on screen: TITLE – Overcoming objectives
Image on screen: The slide displays the following objection by an investor, highlighted in large text in the center of the graph, and reads as follows: “I don’t want to take risk with my money now. I’m trying to protect my principal.” An icon showing a quotation mark is situated above the statement.
The next objection that we sometimes hear is that I don't want to take risk with my principal right now. I'm going to take steps to protect it to the greatest degree. So, when it comes to risk, the question that I would ask is how is the investor defining risk?
Text on screen: TITLE – Defining risk effectively
Image on screen: A graphic highlights various words associated with risk, in various shades and sizes. The word “risk” has the largest font size, dominating the center of the figure. The word “loss,” has a font size about half as large. Words such as “tolerance,” “exposure” and “variance” also have prominence. Other words, less emphasized, include “profile,” “capacity,” “probability,” “drawdown,” “consequence,” “lose,” “fail,” “hazard,” “volatility,” “failure,” “crisis,” and “fail.” Underneath the figure, the text notes that risks are often expressed in the form of probabilities, but for many people, probabilities are less important than consequences and exposure.
Is it market fluctuation? Is it a temporary decline in value? Or maybe the risk that we need to help our clients approach and to solve for is the risk of accomplishing their financial objectives and the question that should be asked is, is a significant allocation to cash assets going to help protect me against that significant risk? There are a variety of different risks that investors face. Some that are immunized with a significant allocation to cash, but others that they may be unaware of.
Text on screen: TITLE – Heavy cash introduces a new potential risk
Image on screen: A figure highlights two risks associated with holding a large amount of cash. They are arranged under blue icons, in a side by side array. On the left, an icon with a dollar sign and arrows pointing up and down, highlights interest rate risk. To its right is an icon pointing out default risk, showing two hands exchange a currency note. Each risk also contains further description.
Of course, interest rate risk is significantly reduced when I maintain a significant cash exposure and default risk is rather nil when I keep money in secure short-term instruments, but there are two other risks that investors may be unknowingly exposing themselves to do
Text on screen: TITLE – Heavy cash introduces a new potential risk
Image on screen: A figure highlights two risks associated with holding a large amount of cash. They are arranged under blue icons, in a side by side array. On the left, an icon shows inflation risk, with an icon of a bar chart trending downward. On the right, reinvestment risk is depicted by an icon with two arrows pointing in a clockwise direction. Each risk also contains further description.
the first of which is inflation risk. The idea that over the long term, a significant allocation to short-term investments may not protect our clients against the ravaging impact of inflation.
Our client's goal, of course, is to increase or improve their purchasing power and cash investments have proven to be a poor protection in that regard. The second risk is reinvestment risk. Today's rates may seem attractive, but the question that I ask generically is what do we do in that capital matures? What will the new interest rate opportunities be once this capital is available for reinvestment?
Now, when it comes to risk, I think it's important for us to define it a little bit more specifically and
Text on screen: TITLE – Bonds have historically experienced less risk
Image on screen: The figure includes two tables showing annual return and average intra-year drawdown of the S&P500 index, and the U.S. Aggregate index. As of 31 August 2023, the S&P500 has had a positive annual return 75% of the time, with an intra-year drawdown of 14.1%. The other side of the diagram shows the U.S. Aggregate generating a positive annual return 89% of the time, with an average intra-year drawdown of only 3.5%.
we'll focus on the two primary building blocks that investors and advisors use in building portfolios, the S&P500 and of course the Barclays AGG. Let's take a look at equities first. 75% of the time, equities produce a positive return experience for the investor and when they endure a negative experience, that loss is approximately 14% on average.
But look at fixed income vehicles, there's a greater probability that I have a positive return by investing in fixed income, almost a 90% occurrence and of course, when fixed income does lose money, that loss is much more muted, an average loss of 3.5%. Now, how do we help our clients?
Redeploy capital that maybe in short-term instruments today to embrace the opportunity to invest it more productively.
Now we've identified three different ways in which to do so.
The first of which is staging our various investments, not necessarily committing all of our capital at one moment in time as a way of spreading that investment risk.
Text on screen: TITLE – Getting back into the bond market
IMAGE ON SCREEN: Reading from left to right: Dollar cost averaging, represented by a dollar bill and globe icon; barbell, represented by exercise dumbbell icon; and ladder, represented by a ladder icon.
Many of you have probably embraced the opportunity of dollar cost averaging, the idea being that the average purchase price that we endure is lower than the average security price of the investments being made. The second approach is a Barbell approach, where we divide our resources into short-term investments that produce greater flexibility and longer-term investments, which lock in a higher interest rate and maybe a greater investment return opportunity.
The third approach is a ladder. A Ladder is a defensive approach to fixed income investing, where an investor might build an investment portfolio of maturities that occur over each of the next five years. In doing so, the investor accomplishes the best of both worlds. Shorter term securities that can be reinvested at a higher rate, if interest rates were to rise and longer duration assets that lock in and protect us with the higher interest rate available today.
The latter approach is proven to be a very defensive way of allocating capital in a fixed income market.
We want to encourage you to have these conversations with your clients to ensure that their cash balances are suitable or sensible for their circumstances and their objectives,
Text on screen: TITLE – Understanding cash positions: Conversation starters
Image on screen: The diagram contains six questions to help gain an understanding in a client’s cash position. The questions are arranged numerically, with the numbers highlighted inside blue colored bullets. The six items include the following questions: What are your reasons for holding a large cash position today? What are your greater concerns about deploying some of your current cash? What are your anticipated cash needs? What are your expectations for interest rates in the future? What do you plan do to with your current short-term holdings when they mature? Are there any alternatives that you have been considering?
and we leave you with six different conversation starters. Number one, what is your rationale for holding a significant cash balance today? Number two, what are your current or expected cash needs? What are your greatest concerns about reallocating that capital into assets that may prove to be more productive?
What are your expectations regarding interest rates? Do you believe that we're close to the peaking rates or do you expect them to continue to rise from here? What do you plan to do when your current investments mature and then finally, are there any alternatives that you may consider for redeployment?
We hope that this conversation today has been helpful to you in bringing these ideas to your clients and overcoming any objections they may have. We want to encourage you to visit the PIMCO website or to contact your PIMCO account manager for additional information. Thank you for joining us today.
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Disclosure
Past performance is not a guarantee or a reliable indicator of future results.
A word about risk: All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions.
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