Better portfolios put liquidity to work

Investors that started the year with growing confidence that inflation was on a clear path lower, and that rate cuts would soon follow, are digesting a new reality.

At this point, policy uncertainty remains elevated, and markets are still grappling with the prospect that not only will rates remain restrictive for longer, but they could move higher from here.

This matters for investors with a whole-of-portfolio view because it changes the job description of defensive capital.

If you believe rates are on an upward trajectory, you can no longer assume the lower-risk portion of the portfolio is best served sitting in cash waiting for a more benign backdrop. Nor can investors ignore the opportunity cost of holding too much capital in structures that are either locked up, or insufficiently productive.

Good portfolio construction is about ensuring each part of the portfolio is doing the job it is meant to do. When every element is doing its job and earning its place, there's very little room for what is termed 'lazy cash.'

In a scenario in which rates are higher for longer, it's reasonable to expect liquidity should be doing more than simply preserving capital. Investors need to think laterally about liquidity, duration and what it means to have 'portfolio flexibility'.

Ideally, the defensive portion of a portfolio is not simply a passive holding area. It needs to generate income, preserve optionality and avoid unnecessary exposure to interest-rate risk. That is why floating rate corporate bonds are coming back into focus.