The fast view
- Interest rates are now expected to remain higher for longer, and therefore money market investors will continue to earn an optically attractive return.
- An analysis of the performance of US cash and bonds, however, shows that bonds outperform cash during both rate-pause, and rate-cutting periods.
- Investors should therefore avoid parking in cash given that both rate-pause and rate-cutting periods have been better for fixed income funds.
- Conservative offshore investors who have an investment horizon of at least 12 months should consider investing in a global diversified income fund, such as the Ninety One Global Diversified Income Fund.
- An analysis of the performance of SA cash and bonds produces comparable results. Conservative local investors should therefore consider the Ninety One Diversified Income Fund as an alternative to money market funds.
In the wake of the fastest interest rate hiking cycle in decades, there is a growing consensus that global rates have broadly peaked. However, sticky inflation, off the back of a more resilient US economy, suggests that interest rates will now remain higher for longer, with the first rate cut now only expected towards the end of 2024. This contrasts materially with the view held towards the end of last year, where the market was predicting six or seven 25 basis point rate cuts each by the US Federal Reserve (the Fed) in 2024.
So, while money parked in bank accounts or money market unit trust funds will continue to earn an optically attractive interest rate, it is not the optimal investment for a conservative investor.
Figure 1: The path of the US Federal funds rate
Source: Bloomberg.
An analysis of post-hike periods in the US since 1990 reveals interesting insights. Before announcing the first rate cut, the Fed typically paused (held rates unchanged) for an average of 10 months. What is more interesting, however, is the relative performance of US cash (as represented by the Bloomberg US 1-3 months Total Return Index) and bonds (as represented by the Bloomberg US Aggregate Bond Index) in the period immediately preceding the final hike, the period during which rates were kept on hold, and then the period immediately following the first rate cut.
Figure 2: The average performance of US cash and bonds at various times in the interest rate cycle
Source: iShares, reproduced by Ninety One.
US cash outperforms US bonds in the six months leading up to the last hike; this being the case as the bond market continues to price in the possibility of further hikes (the peak of the rate-hiking cycle is only ever known after the event), and therefore the income earned on cash exceeds the income and capital return from bonds during this period.
It is then in the rate-pause period, and the period following the first rate cut, when the bond market starts to price in interest rate cuts, that investors earn more from the capital move in bonds than they earn from simply earning the income on cash.
However, while everyone expects bonds to outperform cash materially in a rate-cutting cycle, what is particularly interesting is the magnitude of the outperformance by bonds over cash in the rate-pause period, as shown in Figure 2.
This picture is also evident in the South African context.
The key insight from the above is that investors should avoid sitting on the sidelines in cash, as historically a rate-pause period has been good for fixed income funds relative to money market funds, as has the subsequent rate-cutting period.
For conservative offshore investors with an investment time horizon of at least 12 months, the Ninety One Global Diversified Income Fund offers investors access to the higher income on offer across global fixed income assets. The fund aims for attractive dollar cash-plus returns for limited additional risk; specifically targeting additional income of 1.5% (gross of fees) above US dollar cash over rolling 12 months, while also avoiding annual drawdowns.
The portfolio managers, Paul Carr (based in London) and Adam Furlan (based in Cape Town), can achieve this dual objective by exploiting the vast global fixed income universe of sovereign (government) and corporate debt (spanning 110 geographies), which offers investors attractive income opportunities and a wide range of tools for diversification to mitigate risk. Ninety One is truly unconstrained by geography and asset class. We simply aim to invest where the best opportunities exist, and we have the expertise and investment process to do so.
This flexibility has allowed the portfolio managers to start to increase the fund’s average duration (now over 1 year), which compares to the maximum weighted average maturity of global money market funds of only 60 days. As a result of this and the yield on offer in select, defensive investment grade credit opportunities, the fund’s gross effective yield1 of 5.91% is above that of the Ninety One US Dollar Money Fund at 5.36%, and the less than 1% rate offered on overnight retail bank deposits.
Similarly, conservative local investors should consider the Ninety One Diversified Income Fund. This actively managed, well diversified flexible fixed income fund looks to participate when the South African bond market outperforms cash which, given the above, we expect to be the case as we proceed through the rate pause into the rate-cutting environment. The fund’s gross effective yield is currently 10.76% at a duration of 1.7 years, which compares to the Ninety One Money Market Fund’s gross effective yield of 9.09% and duration of 0.1.
And importantly, both the local and global Diversified Income funds can realise capital gains as local and offshore interest rates enter a rate-cutting cycle.
1 All subsequent yield and duration data at 30 April 2024.
