[Editor’s Note: Do not read the following commentary as a recommendation to invest in cash or fixed-income ETFs. Using ETFs for cash exposure has a different risk profile compared to investing in cash via term deposits. Also, the outlook for interest rates can be difficult to forecast. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article.]

However, yields on bank deposits potentially may not keep up should interest rates continue to increase and trail those currently available in various cash or short-duration bond Exchange Traded Funds (ETFs), in BlackRock’s view.

In 2023, cash ETFs on ASX attracted over $1 billion in inflows, placing them in the top 5 most popular exchange traded product categories. By providing exposure to short-duration bonds that are highly liquid and aim to generate a similar return to traditional cash products, cash ETFs can potentially provide an option for investors looking for term deposit-style income from their excess cash.

Risks

Of course, it is important to note that an investment in fixed income funds is not equivalent to and involves risks not associated with an investment in cash or cash equivalents. When considering cash ETFs as an investment, it may be helpful to think of cash in layers, storing everyday spending money in bank accounts and considering other options for cash that does not need to be used right away.  

Fixed income ETFs – the new kid on the block

Throughout history, other than providing capital preservation, bonds have also played an important role in portfolios, serving to both generate income and diversify portfolios. 

While cash may offer temporary income during tightening cycles for interest rates, BlackRock has seen in the last year that, in normal yield curve environments over the long term, longer-dated instruments can offer greater income potential to a portfolio. 

Cash, however, has limitations in its ability to provide stability and diversification against riskier assets like equities. It has been proven that no one bond fund can do it all. 

The Fixed Income Pyramid can provide a useful reference point when choosing fixed income exposures. Source: BlackRock, for illustrative purposes only.
 

Gaining exposure

There are now a range of different funds and strategies for investors to choose from, with more than 50 fixed income and cash exchanged traded products (ETPs) available on the ASX. 

Fixed income ETPs recorded more than $5 billion in inflows and 36% growth in assets under management last year and became the top product category by inflows for the first time in Australia, according to BlackRock analysis.

[Editor’s Note: The monthly ASX Investment Products Report has information on the size and growth of investment products markets on ASX.]

With more variety available, investors can now afford to be more granular and tailored in their cash and fixed income allocations through ETFs, selecting exposures across different markets, durations and strategies depending on their goals and views on where markets are heading.

If one thinks of a typical “balanced” investment portfolio as a 60-40 mix of equities and cash or fixed income exposures, an investor may have historically built out the fixed income portion of their portfolio with a mix of interest-bearing cash products like term deposits, and fixed income managed funds.

With the evolution of the local fixed income ETF ecosystem, global and domestic bond markets are now easier to access independently, providing the opportunity  to construct a low-cost portfolio based on what an investor wants to achieve from their fixed income allocation. 

For instance, some investors may want to earn a little more on their idle cash with short duration bond ETFs as discussed above; or to achieve a higher level of regular income, and potentially more consistent returns, with corporate or high-yield bond ETFs. 

If the goal is portfolio diversification and low correlation to equities – particularly in a high interest rate environment when the outlook for sharemarkets is less certain - a broad-market bond ETF is a consideration, in BlackRock’s view.

It’s likely many investors may have a mix of these goals, and that they will change over time. Again, this is where ETFs can be a tool to make quick, specific changes within a fixed income allocation, as these ETFs are easily tradeable with no redemption barriers or penalties, and have typically lower ongoing costs than actively managed fixed income funds.

Annual flows into Fixed Income and Cash ETPs indicate soaring investor interest in these products last year. Source: ASX as at 30 November 2023.
 

Preparing for the next chapter

Looking at the broader economic environment, it appears Australia may be nearing the end of central bank tightening. But the case for rate cuts is still far from clear, with any such moves from the RBA so far forecast for the back half of the year, according to BlackRock’s view.

This could represent an opportunity to consider longer-duration fixed income exposures, potentially locking in higher yields ahead of the next stage of the economic cycle [when rates are cut].  

Additionally, following central bank commentary that it may take some time for inflation to get back to target levels , inflation-linked bond ETFs may still be worth considering, in BlackRock’s view. 

With many investors having moved further up the risk curve to generate adequate returns for their investment objectives during the low-rate environment of the pandemic years, a reset of portfolios towards a more balanced split of equities and fixed income could be a consideration in the months ahead.

Lessons from history show there is a risk that investors can miss out on higher yields if they wait too long for rate cuts to be confirmed. 

Whatever surprises the rest of 2024 may have in store for us – with geopolitical tensions simmering and the likelihood of a “soft landing” for the global economy still uncertain - fixed income ETFs remain a tool for investors to access the bond market and navigate changing dynamics. 

With ongoing innovation expected in the fixed income space as the Australian ETF market continues to expand, investors can better prepare their portfolios for a myriad of possible scenarios and respond in real time to developments in the market much like they would with their equity holdings.

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