The Rising Risk of Investing in Cash
Pending Fed rate cuts may make reinvesting in cash equivalents or waiting to redeploy into bonds costly. But we believe there’s still time to manage this mounting risk.
Key Takeaways
With the Federal Reserve (Fed) likely to cut rates later this year, we believe reinvestment risk is a growing threat to fixed-income portfolios.
Falling interest rates mean yields on cash equivalents will likely decline, reducing investors’ monthly investment income.
We believe this scenario highlights current opportunities among investment-grade bonds with exposure to a potentially changing interest rate backdrop.
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Why Is Reinvestment Risk Rising?
Reinvestment risk is the possibility that investors may be unable to reinvest cash flows at the same yield they’re currently earning.
This risk typically emerges when interest rates are falling, such as when the Fed cuts rates. We think Fed easing is imminent.
Looking at the 20 Fed tightening cycles from 1956 through 2019, the federal funds rate target remained at its peak level for an average of 4.2 months.
In the current cycle, the rate target has been in a range of 5.25% to 5.5% for a year, unusual by historical standards.
In our view, history suggests reinvestment risk is rising, making it a key consideration for investors seeking to maximize investment income and total return potential.
Peak Rates Have Been Short-Lived
When Rate Hikes Ended and How Long Rates Stayed at Peak Level
Short-Term Yields Have Moved in Sync
Short-Maturity Yields Have Tracked the Fed Funds Rate
Past performance is no guarantee of future results.
Yields on Treasury bills, CDs and other cash equivalents typically move in tandem with the federal funds rate.
So, when the Fed starts cutting rates, yields on these popular vehicles should follow suit.
This dynamic can lead to less monthly income for investors who hold these assets.
A Dual Challenge for Investors
Reinvestment risk can create two challenges for fixed-income investors:
They may see a drop in monthly income from cash equivalents.
They may pay more to redeploy cash assets into longer-maturity, higher-yielding securities.
For illustrative purposes only. Assumes a bond paying 4% with a fixed semiannual coupon and a 10-year maturity.
Bond prices typically rise in declining interest rate environments. So, boosting total return potential by moving into higher-yielding alternatives may cost more after rates start to drop.
Bond Yields Highlight Opportunities
Persistent inflation and high interest rates have lifted yields across the bond market. In our view, this backdrop means most investment-grade bond sectors may help mitigate reinvestment risk by:
Securing and locking in today’s potentially attractive yields.
Adding duration, which can generate price appreciation when interest rates fall.
Most investment-grade sectors have offered yields of at least 5%. Combined with their duration exposure, we believe the total return potential is sound, given our expectations for rates to fall.
And even if the economy performs better than expected and interest rates move higher, we believe current yields may offer a total return cushion.
Investment-Grade Bonds: Attractive Yield Potential, Modest Duration Exposure
Data as of 6/30/24. Source: Bloomberg, J.P. Morgan, Credit Suisse. Past performance is no guarantee of future results. In our Glossary for Investment Terms, we define High-yield bonds, CLOs, ABS, CMBS, Agency MBS and the Bloomberg U.S. Aggregate Bond Index. For the Bloomberg Muni Bond Index, taxable-equivalent yields may be higher, depending on your income tax bracket. Leveraged loans are loans extended to companies with significant debt or poor credit ratings (below investment-grade). These loans typically have higher interest rates to reflect the higher level of risk in issuing them.
Duration Can Make a Difference
Duration, or a bond’s price sensitivity to interest rate changes, is a gauge that investors use to manage interest rate risk.
When interest rates drop, bonds with longer durations tend to experience greater price appreciation.
Conversely, when rates rise, prices on longer-duration bonds typically drop more.
Because we expect interest rates to decline in the coming months, we believe modestly adding duration may be prudent.
Duration Influences Bond Prices
How a 1% decline in interest rates affects hypothetical bonds with different durations; assumes initial bond value of $1,000.
How a 1% rise in interest rates may affect hypothetical bonds with different durations; assumes initial bond value of $1,000.
For illustrative purposes only.
The Bottom Line
The Fed has indicated its next policy move will likely be a rate cut. With inflation moderating and economic data slowing, the first cut may occur before year-end.
We believe this outlook has elevated reinvestment risk for many fixed-income investors.
In our view, higher-quality bonds with attractive yields and intermediate durations may help investors manage this risk.
Authors
VP, Client Portfolio Manager
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The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Generally, as interest rates rise, the value of the bonds held in the fund will decline. The opposite is true when interest rates decline.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.