COLUMN-Cash is a tool, not a drag, for debt investors today: Fridson

By Marty Fridson

May 12 - Holding high levels of cash is usually frowned upon by asset managers because of the ‘drag’ on portfolio returns, but in this uncertain environment, fixed income investors may be wise to consider doing just that.

While U.S. investment grade and high yield indexes had recovered the majority of the value lost following President Donald Trump’s tariff announcements on April 2, the potential for market disruption remains high.

In connection with ongoing trade talks, Treasury Secretary Scott Bessent recently explained, “President Trump creates what I call strategic uncertainty in the negotiations.” In other words, uncertainty is a feature, not a bug of the current administration’s economic management.

On top of that, bond investors must also grapple with several widely divergent scenarios for long-term interest rates.

First, Trump’s tariffs may wind up having more severe economic consequences than causing children to receive “two dolls instead of 30 dolls” for Christmas. In a recessionary scenario, reduced demand for debt capital, combined with a likely investor flight to safety from stocks to bonds, could push long-term yields down.

On the other hand, if importers chose to pass tariff costs along to consumers, inflation could experience a big upsurge, and spiking inflation is ordinarily associated with a rise in long-term yields.

Adding to the uncertainty, the U.S. might suffer a double whammy of economic stagnation plus high inflation, or stagflation – in which case, long-term yields could behave in unpredictable ways.

In the face of such a wide range of possible outcomes, investors should not worry about being accused of “lacking conviction” if they bump up their cash positions for the time being.

Doing so can provide them with the flexibility to select bonds based on how tariff designations unfold and the impact these outcomes have on U.S. economic activity and inflation. Investors will also be better positioned to buy into the market at lower price levels if new tensions on the trade front – or fresh attacks on the U.S. Federal Reserve – trigger a selloff.

RISK vs REWARD

One of the main objections to holding ‘too much’ cash is obviously the financial sacrifice, but this is far less of a concern today.

Let’s compare the yields on three-month Treasury bills – a cash equivalent – and 10-year Treasury notes.

Typically, longer-dated Treasuries yield substantially more than shorter-dated ones. Over the past 25 years, opting for Treasury bills over the 10-year note forced investors to give up 142 basis points of yield on average. By contrast, the yield sacrifice is currently just four basis points, with the 10-year at 4.34% and the three-month T-bill at 4.30%, as of May 6, according to ICE Indices.

This situation doesn't exactly align with the normal expectation in financial markets that the less price risk you take, the less return you receive.

Just consider the relative risk. Over the past 25 years, the maximum monthly price swings, up and down, for the 10-year note have been +8.73% and -5.52%. The corresponding range for the three-month T-bill is just +0.56% to -0.01%, yet the latter is yielding a mere four basis points less.

Based on these numbers, holding extra cash for a while poses a negligible risk of price loss, far less than the downside price risk associated with investing in long-term bonds. Moreover, with the latest reported inflation rate at 2.4%, parking cash in T-bills yielding 4.30% does not currently subject investors to a loss of purchasing power.

The risk that fixed income investors do face if they opt for a larger-than-usual cash allocation is a potential opportunity cost. If the recession scenario prevails and long-term yields drop suddenly and significantly, the cash portion of their portfolios will miss out on the resulting price gain.

Note, however, that in this scenario, long-term rates would substantially exceed the T-bill rate, so the extra cash could easily be redeployed at a higher yield.

WAIT AND SEE

We all know that trying to time the market on a short-term basis is a losing game. However, if there was ever a good time to engage in active management, the current situation certainly seems to qualify.

And the risk of waiting currently seems low. The Fed appears to be on hold for at least the next few months. While the president is putting pressure on the Fed Chair to cut interest rates sooner rather than later, Powell is resisting that pressure so far and keeping a watchful eye on the inflation data.

Consequently, the danger of missing out on a sudden, Fed-induced drop at the long end of the yield curve does not appear high.

In short, fixed income investors probably have time to wait and watch what emerges from the White House on trade policy. Once the implications of higher tariffs become clearer, investors will be able to decide on allocations with greater confidence regarding both credit quality and interest rate exposure.

Under present conditions, building up a greater-than-normal cash reserve is anything but a decision to avoid making a decision. Rather, it is a way to ensure that important portfolio actions are being shifted from a time of extreme uncertainty to a period when relevant information is likely to be much more abundant.

(The views expressed here are those of Marty Fridson, the founder of FridsonVision High Yield Strategy. He is a past governor of the CFA Institute, consultant to the Federal Reserve Board of Governors, and Special Assistant to the Director for Deferred Compensation, Office of Management and the Budget, The City of New York.)