The Flight To Cash Is Fraught With Risk: Fixed Income To The Rescue

Advisors Should Steer Clients Away From Cash Investments To The Resiliency Of Fixed Income
Jennifer Hutchins, VP, Co-Chief Investment Officer, Avantax Wealth Management
Jennifer Hutchins, VP, Co-Chief Investment Officer, Avantax Wealth Management

A broad wave of macroeconomic and geopolitical events wreaked havoc on the stock and bond markets in 2022, resulting in large declines for major indices. The tumult was punctuated by soaring inflation and aggressive interest rate hikes from central banks, further roiling traditional investments and prompting many investors to consider whether cash was indeed king as rates rose.

Advisors with skittish clients have in some cases tilted allocations away from stocks and bonds, toward the relative safety of cash instruments like high-yield savings accounts, certificates of deposit and money market funds. With yields on these vehicles exceeding 5% in some instances, their highest levels in nearly 15 years, the allure of parking funds in cash has proven difficult to resist for those still haunted by 2022’s market turmoil.

The flight to cash carries its own risks.

However, this flight to cash carries its own risks, including opportunity and reinvestment risk. Savvy advisors would be wise to caution clients against an overcorrection into cash, instead exploring fixed income alternatives that could potentially offer more attractive risk-adjusted returns should unsettled economic conditions persist.

Resist Emotion And Consider The Inherent Risks Of Cash

Making investment decisions based on emotion has always been a terrible idea – but it has clouded the better judgment of even the savviest investors, especially during volatile markets. Emotion-driven investing is a form of market timing, and no one can claim with certainty whether inflation will be sufficiently curbed for the Fed to throttle back their campaign against rising prices and begin cutting rates.

It’s an ambiguous outlook, and the short-term allure of cash’s high yields must be weighed against the reinvestment risk inherent in staking such a position. While a 5% return may seem appealing today, advisors should consider the possibility that rates could potentially decline in the next 12 to 18 months if the Fed embarks on a series of cuts, or if the economy stumbles into a recession.

Either scenario could swiftly erode cash’s advantage and leave clients wondering what other opportunities they may have missed.

Explore Opportunities In Fixed Income

One area that advisors should consider for nervous clients, in lieu of parking them in cash instruments, is the fixed income market. By staying in cash until rates fall, investors may forgo compelling total return opportunities in bonds that could help offset the prior years’ losses.

A calculated allocation to fixed income instruments with appropriate durations, which represent measures of a bond’s sensitivity to interest-rate movements, could enable clients to capitalize on elevated yields while mitigating the reinvestment risks that an outright cash position presents. Careful portfolio construction is crucial in this murky economic climate, and rather than yielding to cash’s siren song, advisors could guide clients toward alternatives.

By staying in cash until rates fall, investors may forgo compelling total return opportunities in bonds.

For example, the duration of the 10-year Treasury note is about eight years at current yields. Should the market experience a 50 basis point decline in yield, the price of the 10-year today would go up approximately 4% – resulting in a return, inclusive of yield, of approximately 9% over the course of a year.

Treasury bonds also warrant consideration, with yields currently hovering around 4.4% for both five and 10-year maturities, nearing their 15-year peak. Longer-dated issues may hold more appeal if the Fed enacts forecasted rate cuts, with the first cut likely occurring during the latter half of 2024. Treasury Inflation-Protected Securities (TIPS) are currently pricing in an annual inflation rate close to 2%, presenting another intriguing option given the improbability of inflation decelerating so quickly.

Diversify Beyond Cash For Resilient Portfolios

While cash undoubtedly holds appeal after 2022’s rout in stocks and bonds, a judicious fixed income allocation spanning diversified issues and durations could better position portfolios to withstand any lingering market turbulence.

Advisors should counsel clients to consider fixed income opportunities that can potentially offer a higher total return than cash. This provides a blueprint for clients, enlightening them on how they might achieve better outcomes by removing emotion from the equation when market volatility strikes.

Jennifer Hutchins is VP, Co-Chief Investment Officer at Avantax Wealth Management.

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