Why Retirees Urgently Need an Alternative to Cash?

Australia In Recession
Australia In Recession – What Does It Mean?
September 3, 2020
5 Things People in Their 20s Should Save For
5 Things People in Their 20s Should Save For
October 16, 2020

With cash rates set to stay even lower for even longer, retirees urgently need higher-earning alternatives for the defensive portion of their portfolios. Actively managed fixed income investments can provide the answer – and the time to act is now.

Key take-outs

  • With the cash rate set to stay at 0.25% (or lower) for at least three years, the return on cash is likely to remain negative after inflation over the medium term. This creates an urgent problem for retirees already seeing the value of the cash portion of their portfolios eroded, putting retirement plans at risk.
  • Well-selected fixed income investments can help provide a solution, lifting returns with only a small increase in risk. While fixed income yields are also likely to stay low for some time, they can still be several times higher than cash, if selected and managed well.
  • To make the most of the fixed income opportunity, we believe it’s important to act promptly, and to take an active and diversified approach that brings together the most attractive fixed income opportunities from around the world.

Cash is set to stay even lower for even longer

A year ago, in our paper ‘Optimising cash allocations in retirement portfolios’, we suggested that the RBA could take the cash rate to as low as 0% by the middle of this year. We had no idea that COVID-19 would be the trigger to get us there – but sometimes it’s nice to be right, even for the wrong reasons!
We also thought that even if cash rates weren’t cut further (from 0.75% at the time of writing), they would likely stay low for a long time. Our reasons for thinking the cash rate would remain lower for longer were that:

  • structural trends in demographics, globalisation and technology were dampening growth and pushing inflation lower
  • debt loads were high, and
  • central banks were likely to continue to use their limited toolkits to pursue their narrowly framed (consumer) inflation targets for some time to come.

All of these reasons are still valid. We’ve also had the big cyclical shock of COVID-19, which has seen the RBA cut rates to 0.25% (effectively zero).

Could rates go negative?

Ideally the RBA’s cash rate would be lower still. Our modelling suggests that, based on the unemployment rate, inflation, and consumer and business sentiment, the cash rate should be about 3% lower than it currently is.

However, the RBA is unlikely to take rates negative, mainly because it thinks the side-effects could outweigh the benefits. Instead, the Bank is committing to buying enough bonds to keep the 3-year government bond yield at 0.25% – which is effectively a commitment that the cash rate will stay at least as low at 0.25% for three years. It may still take the cash rate slightly lower, to say 0.1%.

What does it mean for investors?

These yields obviously offer very little return for the cash investor. And indeed, the return on cash is negative after inflation, and potentially likely to become more so as the RBA holds the cash rate at its current level or lower for years.

With returns on cash so low, both now and for the foreseeable future, it’s increasingly important to consider alternatives to cash – and to do so sooner, rather than later. For retirees and other defensive investors whose primary objective is to preserve capital, every week or month invested in cash risks achieving precisely the opposite result, eroding the after-inflation value of their investment.

In our earlier paper we suggested that retirees should invest part of their existing cash allocation in defensively-oriented fixed income strategies – aimed at generating higher incomes while still largely preserving the key features of cash: certainty and liquidity. Given our even-lower-for-longer outlook for cash rates, we think the argument for substituting some fixed income for cash is even stronger now, and we make the same suggestion today.

Grow your retirement savings

Shouldn’t I stay in cash until fixed income yields are higher?

While it’s true that fixed income yields are materially lower than last year, anyone waiting on the sidelines for them to recover could be waiting a long time. Fixed income yields have fallen for similar reasons to cash returns – a falling cash rate and consequently lower government bond yields. As a result, they are unlikely to go much higher over the next few years, for the same reason that the cash rate won’t.

However, there is also good news. After the initial shock of the pandemic, credit spreads (the difference in yield between government bonds and other fixed income investments) have returned to around their historical averages, so that investors can once again earn a liquidity or credit risk premium, depending on the investments they select. As a result, the prospective return on a well-constructed, diversified fixed income portfolio is likely to be several times higher than cash over the next few years. Figure 1 shows the yield across assets held in the Schroder Absolute Return Income Fund.

Figure 1: Yield to maturity across assets held in the Schroder Absolute Return Income Fund

yield to maturity

Source: Schroders

Wouldn’t I be better off in equities, where possible returns are higher?

The answer is yes, if an investor’s timeframe is long. But for the cash portion of a portfolio, where the timeframe is short and investors typically value certainty, the answer is no. The – stable returns and known cashflows from fixed income provide much greater certainty than variable dividends and the uncertain return of capital from equities. So, to keep the risk profile of your client’s cash bucket low, your client would be much better to be in fixed income than in equities.

What should investors do right now?

We believe retirees can meaningfully increase returns with little additional risk by allocating part of their cash portfolios to high quality fixed income strategies. To best achieve this aim, those strategies should be actively managed, liquid and diversified. Risk management is crucial to manage and control the fund’s aggregated exposure to a variety of risks. In particular, we seek to limit correlation to equity markets and to minimise volatility and manage downside risks.

The most critical element of the investment process in adopting an absolute return approach is to identify which assets to own, how much to own and when to own them. Figure 2 shows the asset allocation of the Schroder Absolute Return Income Fund as at 31 August 2020. Active management is important because it helps investors take advantage of the emerging opportunities in fixed income while avoiding possible risks (such as the heightened risk of default in some corporate bonds). This is then complemented by extensive research and expertise in the fixed income asset class. The targeted result is a well-diversified portfolio with exposures across global credit, rates and currency markets with the potential to deliver consistent returns, with high liquidity but with much lower risk than the equity market.

Schroder Absolute Return Income Fund Asset Allocation

Figure 2: Schroder Absolute Return Income Fund Asset Allocation as at 31 August 2020

Important Information:
This material has been issued by Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFSL 226473) (Schroders) for information purposes only. It is intended solely for professional investors and financial advisers and is not suitable for distribution to retail clients. The views and opinions contained herein are those of the authors as at the date of publication and are subject to change due to market and other conditions. Such views and opinions may not necessarily represent those expressed or reflected in other Schroders communications, strategies or funds. The information contained is general information only and does not take into account your objectives, financial situation or needs. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this material. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this material or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this material or any other person. This material is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any references to securities, sectors, regions and/or countries are for illustrative purposes only. You should note that past performance is not a reliable indicator of future performance. Schroders may record and monitor telephone calls for security, training and compliance purposes.

Leave a Reply

Your email address will not be published. Required fields are marked *

Translate »