With persistent uncertainty in global markets, it’s unsurprising to see increased demand for cash and cash equivalents, especially given short-term money markets are currently yielding circa 5.45% pa.
However, while cash undoubtedly has an important and irreplaceable role to play as part of the investment mix, it shouldn’t be perceived or used as a substitute for fixed-income, and vice versa.
The Case for Fixed-Income
There are several reasons for this, including the fact that cash and money market rates are highly correlated to the economy and business cycle. This means that in the event central banks need to start cutting interest rates sooner than expected, yields on cash and equivalents are likely to evaporate quickly.
In contrast, longer-dated fixed-income securities which are held to maturity can provide greater levels of certainty by removing some of this risk, given fixed coupons are locked in for longer.
Capital Appreciation Potential
In addition to stable income generation, fixed-income securities can also provide capital appreciation given asset prices rise when yields decline. This underscores a fundamental difference to cash, and highlights how an overallocation can be detrimental to long-term performance, especially when the macroeconomic environment changes.
As demonstrated below, a simulated $100 portfolio invested in Baa-rated corporate fixed-income securities from 1928 through to 2022 grew significantly more than both cash and long-term U.S. government debt.
Understanding The Risks of Corporate Fixed-Income
The higher returns on offer from corporate fixed-income securities compensates investors for the increased levels of risk over and above government bonds (depending on the credit rating of the corporate issuing the security). The perceived lack of credit risk associated with governments is why government bonds generally yield less than corporate bonds and other fixed-income securities.
Perhaps the most significant risks associated with corporate fixed-income is credit risk. Unlike government bonds which are typically considered to have minimal default risk, corporations can and do go bankrupt or default on debt obligations.
In the event an issuer of a corporate fixed-income security does default or go bankrupt, then investors may receive some or none of their investment back.
In addition to credit risk, there are various other considerations to be aware of, so it’s important to speak to a specialist corporate fixed-income adviser who can provide you with the relevant information.
While recent economic data coming out of the U.S. suggests that a soft landing is increasingly possible, history shows that most Federal Reserve rate hiking cycles have led to a hard landing. As such, the prospect of policymakers needing to reverse course, and quickly, isn’t completely unthinkable.
In such an event, a healthy allocation to fixed-income securities with longer-dated maturities can support portfolios and complement cash and other assets, should economic conditions deteriorate.
How the Australian Bond Exchange Can Help
Holding enough cash and cash equivalents is crucial for covering any anticipated or unanticipated spending needs however, cash should not be seen as a substitute for fixed-income, and vice versa.
For more information about how corporate fixed-income securities can enhance overall portfolio returns by providing steady and reliable income, speak to an Australian Bond Exchange adviser today.
Data as accurate as 9.10.2023
Disclaimer: Australian Bond Exchange Pty Ltd ACN 605 038 935 AFSL 484453 (ABE). This article is intended to provide general information of an educational nature only. It does not constitute the provision of personal advice and does not take into account your personal objectives, financial situation or needs. Before investing with ABE, you should consider the appropriateness of the investment to your particular financial and taxation situation and consider obtaining independent advice before making an investment. Examples in this article are for illustration purposes only and are not a recommendation to buy, sell or hold a particular investment. ABE makes no representation or guarantee as to the availability of a bond with the characteristics described in this article or that an investment made by you will generate the returns in the illustration. Past performance is not an indication of future performance. Investing with ABE is subject to our Client Services and Custody Agreement Terms and Conditions and Financial Services Guide.