How to position fixed income portfolio for lower rates: Strategists
The U.S. Federal Reserve made a big interest rate cut to kick off its first easing cycle in four years. What does this mean for fixed income? Since the Fed started hiking rates four years ago, cash has poured into short-term money markets such as Treasury bills as they offered attractive yields with rising rates. But yields have started declining, and are expected to continue to do so. Since early this year, Wall Street has also been telling investors to move into bonds — as Treasury prices rise and yields fall. Historically, bond prices and interest rates generally have had an inverse relationship. Prices in some parts of the bond market go up during rate-cutting cycles as older bonds that offer higher interest rates become more in demand. “While this rally in Treasury prices has been welcome for investors who owned fixed income, it does present a quandary as to what to do next for those still sitting in cash,” Citi said in a Sept. 23 note. “With cuts in cash deposit rates and plunging T-bill yields, investors now know the days of 5% for “naught risk” are over.” Nevertheless, it added that it doesn’t think the Fed will lower rates much below 3% in the next year or two. Noting that the Fed has indicated six more possible 25-basis-point cuts till the end of 2025, fixed income markets have priced in cuts in the Fed funds rate from the peak of 5.5% to 3% by the end of next year, the bank said. “We believe diversified portfolios should not exclude US Treasuries even as yields have moved decisively lower,” Citi strategists, led by chief investment strategist Steven Wieting, said in the note. “Investors should consider allocating at least a portion of their investment portfolio to Treasury securities as a core holding to provide some ‘ballast’ should the economy unexpectedly weaken.” “But Treasury Bills in isolation are not a portfolio,” they added. Wells Fargo Investment Institute, too, pointed out in a Sept. 23 note that investors carrying an “outsized cash position” face the risk of losing the opportunity to reinvest cash at the current rate of return. Over time, riskier assets have outperformed cash and cash alternatives, said Brian Rehling, its head of global fixed income strategy. Wells Fargo studied how an invested $1 million has grown since 1926, and it found that small-cap stocks have increased the most, followed by large-cap stocks, and lagging behind was Treasury bills. Its rate of growth “barely” beat inflation, the firm noted. Nevertheless, it acknowledged, “As the bond market adjusts to lower interest rates, investors may find a shortage of investment options to replace a near-5% yield with money market-like risk.” Different types of fixed income Investors can benefit from different types of fixed income in their portfolios, Citi said. These are some options that the bank listed: Investors should consider intermediate maturity investment-grade corporate bonds as “a core fixed income holding.” For U.S.-based investors who can maximize tax benefits, selected investment-grade-rated municipal bonds have the potential to provide additional yield benefit over Treasury yields. Such bonds, as well as intermediate investment-grade corporate bonds, still offer a “much higher” yield over Treasury Inflation-Protected Securities. Investment-grade preferred securities: Yields for these are now higher than BB-rated high yield bonds, the bank said. “Moreover, in the current environment where the yield curve will likely further “steepen” (short term rates drop more than longer term rates), many of these securities may move closer to being called by their issuers, which could result in gains beyond just the interest income as prices rise,” Citi said. Such products trade on exchanges like equities but have par values and pay income like bonds. Like bonds, they are sensitive to interest rates — when rates fall, they are worth more as prices rise and yields drop. The converse is true. The securities have either a very long maturity date or no maturity date, but typically have a call date, which is when the issuing company can redeem them. Wells Fargo said that ideally, investors should move their money from short-term fixed income to stocks or high-yield bonds — as Wells Fargo itself did in early August. But since then, both stocks and high-yield fixed income have increased in price. “Investors should consider taking advantage of any pullbacks in these asset classes to reposition overallocations to short-term fixed income,” it said. Meanwhile, it likes U.S. intermediate term taxable fixed income, as it prefers bonds with maturities of between three and seven years. “We view these maturities as a nice compromise between the declining yields that will be experienced in shorter maturities and the potential price volatility in longer-dated maturities,” Wells Fargo said.
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