Why cash hasn’t been king for UK investors

Many investors have been locking in bond losses while seeming to ignore the attractions of cash so far this year. Why?

Bond funds attracted £10.26bn over the first half of the year—the most successful asset class in terms of inflows. This is likely a result of both institutions topping up their strategic asset allocations following severe fixed income losses in 2022, plus the hope that with yields expanding and expectation that inflationary pressures (and so pressures on base rates) were easing, there was money to be made here. While the latter June have proven a tad premature for early movers, it’s a narrative that’s gained traction.

This is despite the inverted yield curve for most developed markets. ‘Normal’ yield curves are positively sloped, indicating that bonds with longer-term maturities pay a higher yield than shorter-term ones. An inverted yield curve indicates bond investors’ expectations for a fall in longer-term interest rates, thus moving further out on the yield curve. It is also a reliable harbinger of recession.

In the round, investors have received a better return on cash in this environment, both because duration risk causes greater loses on longer-dated bonds as rates rise, and because of the higher yields available at the short end of the curve. To illustrate this, I’ve taken five sterling-denominated bond Lipper Global Classifications and run the average effective duration for each classification against the average return over H1 2023.

As you can see, there’s a significant negative relationship between returns and duration. If rates have further to go—and central banks have indicated as much—then investors are not out of the woods, and this pattern will continue until we hit that anticipated ‘terminal rate’.

Over the year, investors have decided that they will fight the Fed and other central banks—ploughing money into bonds despite central banks warning that there are more rises in the pipeline. That could work if the banks’ medicine works, and the rises choke off inflation quickly, leaving bond investors having locked in an attractive yield as inflation declines and real yields head into positive territory. Another possible outcome is that rate rises choke off both investment and consumer demand, and tip economies over into recession—which should also bring down inflation. Indeed, that is what the yield curve is indicating about investors’ expectations. Investment grade debt, less vulnerable to default, should also perform relatively well in these conditions, although it is a case of “the operation was a success, but the patient died”.

In this environment, cash should be attractive. However, that’s not what we’ve been seeing year to date. Movements in asset classes across regions are broadly correlated. In one important aspect, the UK has bucked this trend in the first half of the year.

Flows to money market funds over the first half of 2023 across Europe were driven by Money Market EUR (+€25.4bn), USD (+€21.2bn), CHF (+€3.0 bn), as well as Money Market Global (+€1.6 bn) and NOK (+€1.0bn). Money Market GBP funds, on the other hand, have seen significant outflows over the period (-€49.2bn).

This isn’t down to European investors dumping sterling in some fit on anti-British pique. It is entirely down to the actions of UK investors themselves. In October 2022, they ploughed £66.59bn into Money Market GBP funds. Subsequently, this tidal wave of cash has ebbed, with redemptions of £54.17bn between November 2022 and June 2023.

Why is the UK such an outlier? This is, of course, a rhetorical question: unless you were in a coma throughout last autumn you know full well. It was the reaction of UK defined benefit pension funds to the 23 September mini-budget.

The announcement of unfunded tax cuts in the September 2022 mini-budget spooked markets, and government borrowing costs spiked. The yield on the 10-year gilt shot from 3.5% to 4.5% between 23 and 27 September. It had been 2% on 15 August. This was the fastest gilt yields had ever risen, and the highest they had been since April 2010.

It caused uproar in pension markets. Defined benefit pension schemes use gilts to match changes in the value of their liabilities—the money the scheme needs to pay out to beneficiaries. There was a risk that DB funds would become insolvent, as the value of their liabilities rose as the value of their assets fell in late September.

UK DB schemes own a large amount of the £2.1 trillion of outstanding gilts, so not only did the spike in gilt yields have a major effect on pension schemes, but their reaction created a negative feedback loop. The more they sold, the more the value of gilts fell, prompting further forced sales, until the Bank of England intervened as buyer of last resort, which acted as a backstop. Schemes also had to rebalance portfolios, selling assets that had not fallen in value to the same degree as gilts, and which now by default were overweights.

The impact in gilt markets was a “full-scale liquidation event” for pension funds, according to the Bank of England’s Executive Director for Markets Andrew Hauser.

Over a short period, money market GBP assets exploded. What we’ve seen in subsequent months has been the unwinding of those positions. By the midpoint of 2023, it was beginning to look like we were back where we started in terms of Money Market GBP flows.

That said, it’s likely that those investors who are not DB pension funds have been increasing their allocations to cash over the period, in line with flows to money market EUR and USD funds—it’s just that this has been overwhelmed by the actions of DB schemes. Between November 2022 and July 2023, £6.38bn has flown back into Bond GBP Government funds—although the actual sum to gilts will be significantly higher, as pension funds will also invest in gilts directly. But the direction of travel is clear.

In summary, as base rates have risen this year, holding cash has become more attractive, at least in nominal terms, while bond holders have continued to suffer in direct relation to the duration of the assets they hold. However, if we are approaching terminal rate territory, with rates maxing out and inflation nosing down, then they may have locked in a decent yield over the coming period.