Investors need to step out of cash and money market funds as the interest rate environment begins to turn, says Colin Finlayson, fixed income investment manager at Aegon Asset Management.
Money market funds have seen assets soar in recent years as investors have sought to benefit from the higher interest rate environment and lower their exposure to risk. In the UK, money market funds attracted a record £4.38bn of capital in 2023, more than in the previous eight years combined, while more than $6trn is now held in US money market funds.
While that trade has worked well for many, Finlayson says that it is now time for investors to re-evaluate their allocations to risk assets like bonds.
“Investor allocations to bonds have been low in recent years with many investors preferring to hold cash or money market funds instead,” he said.
“In the period of low/rising bond yields and high deposit rates, this made perfect sense. Now, as we enter the next phase of the interest rate cycle, this is no longer the case.”
Finlayson believes there is an element of urgency in this now for investors as the bond market alternatives are set to turn with the onset of a falling rate environment.
With bond yields at attractive levels, Finlayson says there is a once in a cycle opportunity now to enter the market.
“Interest rates have peaked. Central banks are now set to cut interest rates and deposit rates, in turn, are set to decline. At the same time, bond yields are at attractive levels again offering the opportunity for both income and capital appreciation.
“For investors over-allocated to cash and underweight fixed income, now is the time to rethink this. The question is how best to allocate back into the bond market with uncertainty and market volatility still present in financial markets.”
For investors unsure of the best route to entry, Finlayson says strategic bond funds offer the best approach, through a combination of flexibility and active management.
“By having the ability to invest across the fixed income universe and having active management of interest rate risk, this type of strategy can help capture the upside potential available but do so while better balancing risks that the bond market brings.
“Crucially, it provides an efficient way to access a range of fixed income market opportunities in a fund that can be held through the cycle.”
Selecting opportunities from across bond markets offers attractive return potential by focusing on the more liquid parts of the bond market, Finlayson argues. But it also offers the ability to actively manage duration risk.
“This will be crucial looking forward as interest rates decline and investors seek more duration sensitive solutions,” he said.
“Strategic funds’ ability to alter asset allocation and duration risk means they can adjust and adapt to changes in the economic and market backdrop. This approach is essential in the coming period.”
