The past two years have been a roller coaster for stock and bond markets, leaving investors somewhat unsettled. Much of that volatility was caused by a surge in inflation following the pandemic and Russia’s invasion of Ukraine. The Federal Reserve’s interest rate hikes, designed to quell that inflation, only added to the market’s unpredictability.
One bright spot through all of this? As a result of those Fed rate hikes, cash finally ceased to be trash. Investors couldn’t help but notice the optically high 5% rates on high-yield savings accounts and money market funds with so much uncertainty lurking elsewhere in the markets. The chance to finally earn a meaningful yield understandably lured many investors, who allowed their cash on the sidelines to swell.
But that cash came with a cost. The S&P 500 returned 26% in 2023, including dividends, and municipal bonds generated over 5%. A 60/40 portfolio of stocks and bonds delivered over 17%. Meanwhile, money market funds only yielded around 3%, after accounting for taxes for those in the highest bracket.
For some time now, it’s been appropriate for cash-heavy investors to reallocate some of that excess cash on the sidelines—whether to stocks or bonds—and to bring their portfolio weights back to long-term strategic levels. That starts with a fresh look at your asset allocation to make sure it’s structured appropriately and effectively implemented. For those who haven’t yet done so, the time is now. From there, consider exploring new ideas, such as the ones outlined below.
Putting Cash to Work Doesn’t Have to Be High Stakes
Still feeling cautious about the economy and the markets? Then high-quality intermediate duration bonds should be your first stop for cash on the sidelines. Just because the train may have left the station in 2023, you don’t have to get straight on the equity express track.
With the Fed having effectively declared an end to rate hikes, the risk-reward in bonds has quickly turned favorable. The steep losses that bonds withstood in 2022 and their volatile nature in 2023 was mainly due to the sharpest rate hiking cycle unfolding in decades. Going forward, the greatest risk—a further rise in interest rates—has largely been mitigated, in our view.
What’s the trade-off between cash and bonds? Cash does well as rates rise, while bonds suffer. Yet once rates stabilize (let alone fall), bonds have the upper hand. Reinvestment risk is the Achilles heel for cash. If rates fall, by definition, your cash on the sidelines won’t keep earning the same high yield. We think that calls for extending duration (buying bonds with maturities further in the future) today. Doing so allows investors to achieve two important goals:
- Lock in attractive interest rates for a longer time
- Benefit from bond price rises if and when rates fall.
Investment grade bonds look particularly attractive right now. High-tax investors should lean into municipal bonds, where fundamentals are shaping up to be stronger than ever. Lower- or tax-exempt investors can find value in high-quality corporate issuers, where fundamentals remain quite healthy for this phase of the economic cycle.
Equities but with Milder Risk
Some investors may be tempted by today’s equity market but remain cautious due to the prevailing macro environment, recent market rally, or current valuations. If that resonates, buffered ETFs may make sense for you. Using a series of options on the S&P 500 index, these strategies create a payout structure that offers a unique advantage. It allows investors to benefit from an initial rise in the stock market while also protecting them against an initial fall.
While the exact terms vary, we’ll use a simple version to illustrate. At the end of December, investors could buy an ETF that would allow them to participate in the first 14% of any gains in the S&P 500 during 2024. At the same time, they’d be protected against the first 15% of losses. So, if the S&P 500 falls by 20% at some point in 2024, they’d only lose 5%, and if it retreats by 10% their principal would remain intact. On the flip side, if it climbs 10%, they’ll capture the full amount, but if it rises by 20%, they’ll only gain 14%.
With so much uncertainty in the economy and markets right now, we’ve seen a healthy appetite among investors for this type of “participate-and-protect” payoff. It’s not a panacea, but it can help some investors ease cash on the sidelines back into the market.
When Opportunity Knocks
Some of the most attractive risk-adjusted returns we’re seeing right now across all asset classes and geographies fall under the broad banner of private credit. That term covers a wide variety of investments, with a range of underlying assets, levels of seniority, yields, and protective covenants. From our standpoint, the opportunity is largely being driven by banks stepping back—partly due to heightened regulation and partly due to finding themselves a bit “over their skis” when it comes to lending at this point in the cycle. As a result, we’re able to step in and let our investors serve as the bank for a range of compelling businesses.
For instance, we’ve already noted the latest developments in commercial real estate (CRE) over the past year, underscoring why we consider it a generational opportunity to lend into this space. Put simply, bargaining power sits squarely in the hands of lenders at the moment. With asset valuations resetting, financing structures requiring adjustment, yields rising, and more protections becoming available, this is the best environment for CRE lending we’ve seen in years. All is not without risk, though. The market is undergoing some serious upheavals and it requires an experienced team to navigate that backdrop, target the right assets, and lock in favorable terms.
Direct lending to middle-market companies—historically a staple of commercial banking—is another area of private credit we’re drawn to. As banks have retreated, it’s widened the universe of companies for us to lend to while offering deals at floating interest rates. Unlike in the bond markets, those variable rates have been beneficial when rates rise. Yet because we lock in financing and capture the spread, the strategy should perform well even in a falling rate environment. Among other things, that would relieve companies of some of their interest burden and boost their health throughout the cycle.
A final area of private credit that we like is a bit of a catch-all. Among other names, some might call it “specialty finance.” Part of it involves lending against specific hard assets—planes, ships, industrial equipment, etc. But it also includes working with banks and businesses to create attractive financing structures that benefit all parties involved. These structures enable businesses to achieve their objectives, banks to make a healthy profit while managing their regulatory capital, and investors like us to earn significant returns—while protecting the downside with seniority, security, protective covenants, and attractive financing.
The risk-adjusted returns we’re seeing in these areas stand out relative to other assets. But there’s a catch. Since these are loans, the interest payments received are taxed at ordinary income rates. That can take a large bite out of the net returns for high-tax investors. Some may be able to work around that with private placement life insurance or private placement variable annuity (PPLI/PPVA) structures. Others may use an insurance-dedicated fund (IDF) to access these types of investments.
Don’t Give in to Inertia
Investors may have felt comfortable holding elevated amounts of cash on the sidelines over the past year or so, given optically high interest rates and the security it brings. Yet taxes still ate into those returns and the markets moved on without them.
As the economy moves forward from here, we recommend that investors right-size cash to its strategic target, while taking advantage of areas of the market with relatively attractive risk-adjusted returns. High-quality intermediate duration bonds, defined-outcome ETFs, and private credit are all worth investors’ consideration as we turn the page to 2024.