The Fed will soon cut rates. How to revamp fixed income investments

If you were waiting for your cue to step out of high-yielding money market funds, the bell is about to ring: The Federal Reserve is widely expected to start cutting interest rates on Wednesday afternoon. Central bank policymakers embarked on their rate-hiking journey in March 2022, which had the pleasant side effect of boosting yields on a range of plain-vanilla investments, including Treasury bills and certificates of deposit. Currently, the Fed’s benchmark interest rate sits at a target range of 5.25% to 5.5%. But the days of 5% yields on money market funds are numbered, even as more than $6.3 trillion in assets are sitting there. Those yields are expected to start coming down sharply as the Fed begins to ease back on generationally high rates. Already, the 2-year Treasury yield, especially sensitive to Fed policy, has cooled significantly in recent months and now sits at 3.59%. In April , it topped 5%. “Believe me, we were on the road for a year, encouraging people to extend duration,” said Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. “It’s a tough sell if you are sitting in T-bills or money markets at 5%.” Adding some duration Duration refers to a bond’s price sensitivity to changes in interest rates. A bond yield moves inversely to its price, so that when bond prices rise, yields decline. Further, issues with longer maturities tend to have greater duration. “We favor the intermediate-term portion of the curve, which provides attractive yield opportunities while not being overly exposed to negative price movements should yields move above our target levels,” wrote Tony Miano, investment strategy analyst at Wells Fargo Investment Institute in a report on Monday. His team sees the Fed cutting benchmark rates by 1 percentage point in 2024 and three quarters of a point next year. He highlighted high yield taxable fixed income as a possible home for investors’ excess cash. The intermediate term segment of the yield curve generally focuses on issues with a duration of five to seven years, a sweet spot for investors who want to lock in some income without being exposed to dramatic price swings in longer-dated instruments. Diversify your holdings Diversification should also be a priority for investors who are stepping out of cash and hoping to snag some yield. “I would look beyond the Treasury market and use investment grade bonds,” said Jones, adding that tax-free municipal bonds may make sense for investors who are in high income tax brackets. Municipal bonds offer income free of federal taxes, and they are exempt from state levies if the investor lives in the issuing state. Although their yields are lower compared to corporates and Treasurys, municipal bonds are especially valuable to high-income investors: With a tax-free yield of 3%, an investor in the 32% bracket would need to find a taxable bond yielding 4.41%, according to New York Life Investments . As far as corporate bonds, “Investment grade corporate yields are still hovering close to 5%, 4.5% for higher quality bonds, and you can lock that in for five to seven years,” Schwab’s Jones said. For additional diversification, Cetera Investment Management chief investment officer Gene Goldman likes mortgage-backed securities. Though investors in the space may be concerned about prepayment risk – especially as interest rates come down and homeowners look to refinance – Cetera says that worry may already be priced in. “Mortgages are tied to the 10-year Treasury yield , and we have seen a lot of the move,” Goldman said. “We don’t think it will move that much further down.” The yield on the benchmark 10-year note topped 5% last October , but it’s trading at about 3.65% on Tuesday. Investors wishing to simplify their approach and still diversify the fixed income portion of their portfolios could use core bond exchange traded funds. These funds tend to hold a combination of government bonds, corporates and securitized debt – for instance, those mortgage-backed securities. Know your purpose If you’re redeploying cash into fixed income, keep your time horizon in mind, as well as your need for liquidity. The general rule of thumb is to have 12 months in liquid cash set aside for emergencies. James Shagawat, certified financial planner at AdvicePeriod in Paramus, New Jersey, has recommended short-term bond ladders for clients who want to earn a little interest on money they’ll need in the next three to five years. Laddering involves buying issues with staggered maturities and reinvesting the proceeds as bonds mature. In an environment with falling rates, the maturing bonds are being reinvested at lower yields, but the investor likely already locked in the higher yields on the issues at the top of the ladder. “I like the ladder,” Shagawat said. “Mixing the terms gives you more income stability.”