Fixed Income in Focus: Rethinking Cash Allocations

As central banks navigate diverse economic conditions, they appear to be shifting to an accommodative monetary stance, making an opportune moment to reassess cash and cash equivalent allocations in client portfolios.

Where we’ve been

In the wake of the loose monetary policy that followed the global financial crisis and COVID pandemic, cash allocations were viewed as a drag on performance. The slogan “cash is trash” was widely adopted by advisors and investors alike. 

Figure 1

But as the saying goes, one central banker’s trash is another’s treasure. The inflation concerns that followed the COVID era put an abrupt end to accommodative monetary policy. Overnight rates across many developed economies increased rapidly, boosting returns paid to savers. As seen in Figure 1, Canada's overnight rate rose at its fastest pace in 40 years.

Cash, once again, was king.

In this rising rate environment, bond yields rose along with underlying rates, while prices of bond funds and ETFs fell. This is a departure from the traditional source of portfolio insurance and diversification from equity risk.

Many investors were surprised to learn that money can be lost in the supposedly safe fixed income market. Suddenly, bonds were topical for all the wrong reasons. Interest rate risk and duration management became major talking points during investment reviews.

Against this backdrop, astute advisors strategically reallocated funds to guaranteed investment certificates (GICs) and high interest savings account exchange traded funds (HISA ETFs), shielding client accounts from volatile fixed income.

Where we are

Driven by challenging housing market dynamics and an economy that is very sensitive to higher interest rates, concerns have increased about a hard landing in Canada. Additionally, potential tariff threats from the southern border add to the uncertainty.

As the aggressive tightening of monetary conditions is felt by consumers and data begins to reflect a moderating of sticky inflation and slowing economic growth, BoC has cut policy rates by 2%. While its widely believed that monetary policy will remain accommodative, the market now broadly believes to see another 0.50% rate reduction in 2025, and it is even likely that we may get more as reflected in Figure 2. 

Figure 2

Currently there is a tremendous opportunity for those astute advisors who shifted client assets into cash in the face of rising rates to reallocate to fixed income, taking advantage of the higher corporate bond yield and the prospect of falling rates in the future.

Where we’re going

As the saying goes, “all good things must come to an end.”

Figure 3

In our view, for holders of GICs and HISA ETFs, the best days are likely in the past. Traditionally, in a stable rate environment a portfolio of short-term bonds will outperform cash and cash equivalents, including GICs and HISA ETFs as we see in Figure 3, primarily due to term premia and credit spread capture. In a falling rate environment this outperformance can be quite material as bond prices rise when yields decline.

There are also external factors negatively affecting the prospects of cash proxies:

• Recent regulatory changes by the Office of the Superintendent of Financial Institutions (OSFI) have narrowed HISA ETF margins, causing yields to decline to approximately the overnight rate.
• GIC rates are significantly influenced by the yield of government bonds which are 2% below their peak levels from 2023. If the economy does cool off or enters a recession due to possible tariffs, GIC rates likely have only one direction to do – lower. If we look back to past instances in Figure 4 when a policy tightening cycle ends, on average, short term fixed income outperforms GICs over every time horizon. 

Figure 4

In addition to the prospect of higher returns, short term fixed income funds and ETFs provide benefits not available to holders of GICs or HISA ETFs.

Tax treatment

While bond coupon payments are subject to the same full taxation as interest payments from HISAs and GICs in non-registered accounts, any capital appreciation for bonds priced at a discount is treated as a capital gain and taxed at a more favourable rate. Currently the vast majority of short-term bonds in Canada are priced at a discount — an incredible opportunity to capitalize on capital gains.

Liquidity

GICs require investors to lock-in funds for a specified period, charging a significant interest penalty should funds be needed prior to maturity. Fixed income funds and ETFs are highly liquid, offering investors the option to access their funds at any time. This flexibility provides advisors the ability to reallocate capital based on market opportunities, not a maturity schedule.

True downside protection

Prior to the lower for longer interest regime, fixed income served as the traditional ballast in portfolios. The zero-interest rate policy radically changed this dynamic, eliminating the negative correlation between bonds and equities. As rates have risen, so too has the potential for bonds to provide stability for portfolios once again.

Investment solutions

In general, how a client’s cash allocation is held depends on whether it is a strategic or tactical position. A short-term tactical position requires liquidity to ensure opportunities are not missed, whereas a strategic allocation will typically seek incremental yield, potentially sacrificing liquidity.

Whether an advisor is considering reallocation of tactical or strategic allocations, Mackenzie can provide options to best manage client cash. Money market funds and ultra-short-term bond funds can provide the liquidity and a healthy degree of capital preservation. A strategic allocation may be better served by an allocation to a short-term bond fund.

Source: Mackenzie Investments as at January 31, 2025

Source: Morningstar as at January 31, 2025

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