MODERN FINANCE
Is Cash Trash?
A
By Philip Dudley
s 2023 comes a close, a strong case can be made that the Federal Reserve is done raising interest rates and one should extend duration in their fixed income portfolios. Duration is a measure of a bond’s sensitivity to the movement in interest rates. Put another way, a one per cent change in interest rates will affect the market price of a bond portfolio by its duration. The current debate of whether the Fed is done raising interest rates is almost irrelevant due to the fact that real rates are finally positive again. Leaving your money in cash might seem like a safe move in these volatile times but sitting on the sidelines can actually be a dangerous game. Even Philip Dudley if the Fed is not done, or even if they are almost done, reinvestment risk is now starting to enter the conversation. Reinvestment risk is the risk of reinvesting in the future at a lower interest rate when compared to the original yield. When the Fed embarked on its relentless tightening cycle in 2022, interest rates went up and bond prices fell. Bond portfolios experienced epic declines not seen in decades. This is the first investment lesson in fixed income, yield and price move in opposite directions. So, if the tightening cycle is over and the economy begins to weaken and the Fed actually cuts interest rates in late 2024, the opposite of “interest rate up – bonds down” could occur. With a current target fed funds rate of 5.25 to 5.5 percent, extending duration could lead to capital appreciation in bonds. Does the Fed keep interest rates “higher for longer?” Or do they overtighten? Again, one can only speculate on the Fed’s future actions, but whatever course they take, the end game is clear. Directionally, interest rates should move down from here, which lowers the potential risks of adding duration. To summarize, if interest rates do indeed fall, those allocating to high levels of cash will be faced with reinvestment risk and no opportunity for capital appreciation. Conversely, those who extend duration will be in a position to buy bonds at a discount to par value. In the event rates decline, the holdings will appreciate towards par (par equals 100). Consider the following, a one year forward return for a 5 percent bond at par maturing in five years would be 1.5 percent if rates moved up 1 percent. But if rates moved down 1 percent, the rate of return for the same bond would be 8.6 percent. The best advice: as the end of the year approaches, do yourself a favor and start thinking longer term.
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Country ZEST & Style | Holiday 2023
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