For months, financial markets have been eyeing the roughly $6.4 trillion in U.S. money market assets in hopes that reallocating just a portion of that money could provide a technical tailwind for stocks and bonds. The rationale for this shift makes sense given that inflation is receding, the next policy move is likely to be a rate cut, and the economic cycle has lengthened. However, we believe it is overly optimistic to assume that cautious investors will significantly increase their exposure to the riskiest asset classes.

This more cautious view is based on the fact that cash offers relatively attractive yields for the first time in more than a decade, and on the memory of fixed-income investors suffering double-digit losses during the inflation surge of 2022. However, for the reasons stated above, a significant number of money market investors may feel that now is the right time to gradually take on risk - but without completely abandoning a cautious mindset.

For those who prioritize low volatility, transparency, and a degree of capital appreciation that money markets cannot provide, we believe the logical destination on the risk spectrum would be fixed income, namely the front end of the yield curve and the higher-quality corporate credit there. As the global economy emerges from more than a decade of price distortions—first caused by highly accommodative policy and then by the post-pandemic wave of inflation—we expect the relationship between short-term bond and money market returns to return to historical norms, which will favor the former.

Investor psychology and policy generosity issues

Over the past four years, money market funds have doubled their assets under management to nearly $6.5 trillion. There are both supply and demand factors behind this growth. On the supply side, we can look to the stimulus packages during the pandemic. On the demand side, we can attribute it to the attractiveness of cash yields and investors' reluctance to take on additional risk when inflation remains high and the global economic trajectory has not yet fully stabilized.

The latter rationale has weakened in recent months as the near-term economic and policy trajectory has become clearer. As economic risks recede, we believe more money market investors will realize that there is an opportunity cost to maintaining large cash allocations—a fact reflected by resilient financial markets. While having a liquid emergency fund has its benefits, we believe now is the best time for investors to put some of their cash back into the capital markets, especially now that bonds are once again offering an attractive income stream, low volatility, and capital appreciation potential.

Coexisting with the old

The shift to shorter-dated fixed income could mark a return to the historical relationship between money markets and one- to three-year bonds. In the two decades before the pandemic, the market capitalization of the Bloomberg U.S. Aggregate 1-3 Year Index consistently far outstripped the assets under management of U.S. money markets. The reason is simple: Since 1996, the index has outperformed money markets on a rolling one-year and three-year basis (calculated on a monthly basis) by 75% and 84%, respectively.1 Even more striking, short-dated bonds have always outperformed when policy rates fall.

We believe this historical relationship is well-founded. A modest cash allocation is a useful tool for managing liquidity and positioning for future investment opportunities. But as noted above, in almost all environments, there are opportunities for investors with a slightly higher risk profile to earn returns in excess of cash.

Embrace the front end

Typically, the front end of the yield curve represents the least risky part of the fixed income universe because investors can more easily gauge inflation and other factors that could affect a bond's value in the short period before it matures. While the downward movement of the yield curve toward maturity generally produces a quantifiable income stream, yields in this part of the curve are typically lower than those of longer-dated bonds because investors trade lower volatility for higher returns. However, this is not currently the case given the persistent inversion of the U.S. Treasury yield curve.

For two years, short-term bonds have offered higher yields than long-term bonds, meaning investors can get higher yields for less interest rate risk or duration. In addition, interest rate cuts are imminent in developed markets, which could lead to some capital appreciation for short-term bonds tied to policy rates. Money market holdings may not receive such benefits - just lower yields on short-term bills that mature quickly.

Investors must also remember that the maturity of liquid securities held by money market funds is capped at slightly longer than one year. If interest rates fall, this year's attractive yields will not continue into next year. In contrast, if bonds with maturities of one to three years are held, today's yields will be more durable.

Clear credit

Another risk that is easier to assess in the short term is the possibility of a credit event. Even with that possibility, corporate credit often trades at a discount to par, meaning that — similar to U.S. Treasuries — investors can often earn a roll yield on these bonds as they approach maturity.

Strategies premised on capturing this roll cannot avoid all credit risk. However, by focusing on higher quality investment-grade credit, investors in current money markets will be able to generate incremental returns without taking on much additional risk. Supporting this approach is the relative strength of investment-grade balance sheets and companies that will not face a wave of refinancings in the coming years. In addition, recent new issuances of investment-grade credit have been oversubscribed, reinforcing strong demand for these securities.

One way to gauge the attractiveness of different parts of the bond market is to determine how much a rate hike would wipe out one year’s yield. While we do not expect rates to rise, this exercise still gives us a sense of the relative value of bond sectors. Notably, the historical relationship between yield and maturity has resurfaced for both US Treasuries and one- to three-year corporate bonds. Unlike much of the post-global financial crisis period, short-term bonds today are generating yields that are more than adequate to weather all but the highest rate swings. Even as yields reset, this is not the case for many long-term bond market segments.

Another way to measure the relationship between risk and return for different fixed income categories is the Sharpe ratio. Over longer periods, shorter-dated securities have higher Sharpe ratios, indicating a more attractive trade-off between potential return and potential risk.

Over the long term, shorter-dated fixed income securities exhibit higher Sharpe ratios, indicating a more attractive balance between return and incremental risk levels. Source: Janus Henderson, as of 30 June 2024.

The right amount of risk

The market volatility of the past few years has given investors good reasons to consider an allocation to cash, as cash yields are well above 0%. However, markets and the global economy continue to evolve in a way that weakens the case for holding too much cash. As with money market strategies, yields on short-term bonds have returned to attractive levels. However, unlike money markets, bonds have the potential to appreciate if developed markets continue to lower policy rates over the next few quarters, which is what we expect.

This appreciation is achieved as a result of an extended economic cycle, further demonstrating the need to methodically take on additional risk. However, the extended cycle could still be a late-cycle one. Given this, we believe quality should be prioritized, and well-capitalized investment-grade credit may be a more appropriate investment target than high-yield bonds or more speculative stocks.

On the surface, valuations for quality companies appear premium based on yields relative to benchmark yields. However, this segment of the market is not static. Behind these narrow spreads, we see considerable variation in valuations across sectors, credit ratings, and even regions. As the ultimate path of interest rates becomes clearer, we expect market volatility to continue to exacerbate this variation, which could create opportunities for rigorous research to identify individual securities with the most attractive risk-reward propositions.