Rethinking the dash to cash

Key takeaways

• Investors have piled into cash since the start of 2022.
• While higher yields may make cash appealing, higher cash balances may actually reduce client’s ability to achieve their long-term investment goals.
• Reinvestment risk and the opportunity cost of owning cash relative to other asset classes are reasons we believe clients should consider a multi-asset approach for income investing.

Investors have piled into cash since the start of 2022. In fact, more than $5.6 trillion is sitting in US money market assets today, up $1 trillion from a year ago.¹

Though higher yields coupled with a still uncertain macroeconomic outlook may make cash appealing, the potential risk of over allocating to cash is that it may affect investors’ ability to reach their long-term investment goals as compared to other investment options. This is particularly worrisome as we approach the end of the Federal Reserve’s hiking cycle. Going back to the mid-1990s, in the year following the last Fed rate hike, money market funds meaningfully underperformed a wide array of asset classes on average, as the chart below illustrates.

And the trouble may intensify once central bankers go from pausing rate hikes to cutting rates. While this may not happen in the near-term, markets are currently pricing in approximately 2-3 rate cuts in 2024 in the US.² But in an environment of falling interest rates, an overconcentration in cash could expose investors to an often underappreciated but potent force: reinvestment risk.

Reinvestment risk: a powerful multiplier

Should the Fed start cutting rates, cash returns may erode quickly as investors are forced to reinvest at lower yields. To better understand this dynamic, we looked back over the last 30+ years to quantify the relationship between starting yield and future total returns.

What may be surprising is that the link between cash yields today and future returns is weak. Why? Because there is no guarantee that prevailing yields one or three months out, when that hypothetical cash-like instrument matures, will still be as high as the initial investment rate. In other words, the durability of cash investments’ return stream is unpredictable. As the chart below illustrates, the dispersion of forward returns for cash at various yield levels is quite wide, and a higher starting yield does not necessarily translate to a favorable three-year return experience.

In contrast, for a blended multi-asset portfolio comprised of global dividend stocks, investment grade bonds and high yield, starting yields actually had a much more positive predictive relationship with ensuing three-year returns. This is due to reduced sensitivity to short-term rate policy, brought about by owning fixed-rate investment grade and high yield bonds, which allow investors to “lock-in” higher starting yields for a longer period. This can be a powerful return driver especially when combined with the greater upside potential of equities.

If not cash, then what?

For investors with a longer time horizon, we caution against over-allocating to cash given the associated reinvestment risk relative to other opportunities in today’s unique yield environment. Here are a few areas we favor in our multi-asset income portfolios:

1. Undervalued dividend stocks complemented with covered calls

Dividend equities can offer a nice blend of growth, quality and stability, along with a steady and often growing cash flow stream. Today, the discount for dividend stocks is extreme, and we believe this group has more reasonable earnings expectations compared with growthier parts of the market that have been the big year-to-date winners.

Complementing dividend stocks with a covered call strategy enables investors to take advantage of elevated volatility. Covered calls are a strategy in which investors own the underlying stock and sell away upside after a certain share price is hit, leaving room for some capital appreciation while collecting additional income via the option premium. While we see potential for gains across our equity holdings, we do not believe an environment of tight monetary policy, reasonably low economic slack, and still elevated uncertainty is one where large upside moves in stocks are likely. Combined with an elevated volatility regime, this is precisely the environment where covered calls can be most valuable.

2. Select opportunities in higher yielding credit

The current yield profile of the US High Yield market continues to offer attractive carry and overall strong fundamentals. However, index levels don’t tell the full story as dispersion continues to sit at elevated levels. In our Multi-Asset Income model portfolios, we recently added to a strategy with exposure to “Fallen Angels,” a sub-set of High Yield bonds that were recently downgraded from investment grade. This strategy provides an up-in-quality access point to higher yielding parts of credit markets, without sacrificing significant yields. For instance, as of September 30^th 2023, Fallen Angels had a yield of 8.33% and 79% BB-rated exposure (the highest quality part of the High Yield market) versus a yield of 8.91% and only 47% BB-rated bonds for the broad High Yield index.³

It may be the time to consider moving away from cash investments

Today’s inverted yield curve wherein the front-end is out yielding longer duration bonds has tempted many to pile into extremely short-term cash investments. This would be a mistake, in our opinion. With a Fed that has been vocal about nearing the end of its hiking campaign, the era of ultra-high short-term rates may be coming to a close. As the chart below illustrates, yield curves don’t remain inverted for long periods of time. Since 1971, the yield on the 2-year Treasury has only been higher than that of the longer-dated 10-year Treasury 15% of the time.⁴

10-Year Treasury Yield Minus 2-Year Treasury Yield
Below O means yield curve inverted

We think investors could benefit from locking in income opportunities that can support them for the next several years, not the next several quarters. By investing in a multi-asset income portfolio with a moderately longer-duration profile, investors have an opportunity to tap into today’s higher yields and potentially realize price appreciation as well.

The BlackRock Multi-Asset Income Model Portfolios provide a core option for investors looking for attractive income levels and diversification beyond cash investments.

Performance data represents past performance and does not guarantee future results. Investment return and principal value will fluctuate with market conditions and may be lower or higher when you sell your shares. Current performance may differ from the performance shown. All returns assume reinvestment of all dividend and capital gain distributions. Refer to blackrock.com for current month end performance. 

To obtain more information on the fund(s) including the Morningstar time period ratings and standardized average annual total returns as of the most recent calendar quarter and current month-end, please click on the fund tile. The Morningstar Rating for funds, or "star rating," is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods. 

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