With the Federal Reserve’s outlook for rate cuts now 180 degrees different from January, now is a good time for investors to reassess their fixed income allocations. There have been signs of easing inflation since the start of the year, with the Consumer Price Index remaining flat in May, and the job market slowing, but policymakers have kept interest rates on hold for now, with the benchmark federal funds rate currently at 5.25% to 5.50%. Federal funds rate futures suggest there is about a 78% chance that the central bank will ease interest rates in September, according to CME FedWatch. This is a big change from the start of the year, when the market was expecting six Fed rate cuts. The outlook for interest rates to be “higher for longer” also makes short-term fixed income assets particularly attractive. According to the Investment Company Institute (ICI), the seven-day current yield of the Crane 100 Money Fund Index is 5.13% annualized, and total money market fund assets have grown to $6.15 trillion as of July 2. Asset managers are struggling with how the changing outlook will affect asset allocation, and they appear to be cautiously increasing their exposure to longer-term bonds while finding opportunities at the shorter end of the yield curve. “The labor market has softened a bit, and while the Fed believes interest rates will fall in the future, it’s hard to predict how quickly they’ll get there,” said Don Calcagni, chief investment officer at Mercer Advisors. “What do we do with this ambiguity?” Striking a balance Bond yields and prices move in opposite directions to each other. Longer-term bonds also have a higher price sensitivity to interest rate changes. This is called duration, and it has to do with the maturity of the bond. Ahead of the rate cuts, financial advisors are recommending increasing exposure to longer-term bonds. This allows investors to lock in higher yields and benefit from price increases when interest rates fall. But the prolonged high interest rates over the past year have made short-term instruments like cash, Treasury bills and money market funds even more attractive to investors. Investors who are too concentrated in these investments may see their income decrease when interest rates fall. Asset managers have tried to get the best of both worlds by adding some duration and diversifying into a variety of fixed-income assets. “We’re trying to position our clients in maturities between two and seven years,” said Shannon Sakocia, chief investment officer at NB Private Wealth, a subsidiary of Neuberger Berman. “At the beginning of the year, we had a lot of investors who were in fixed-income bonds with durations under two years, if not in cash.” Sakocia focuses on quality, focusing on investment-grade corporate bonds, asset-backed securities and mortgage-backed securities. Municipal bonds, which provide income free of federal tax, remain attractive, she said. Stepping into shorter-term assets “There are interesting opportunities and decent yields available, despite the tight spreads in the market,” said Michael Rosen, chief investment officer at Angeles Investment Advisors in Santa Monica, Calif. He is especially seeing solid yields from high-quality collateralized loan obligation securities backed by loan packages to companies.There is an element of risk in that the underlying loans may be made to non-investment-grade borrowers. Rosen noted that AAA CLOs offer yields more than 100 basis points above comparable corporate credits. Indeed, retail investors looking to get into the space can get in through the Janus Henderson AAA CLO ETF (JAAA), which has a 30-day SEC yield of 6.67% and an expense ratio of 0.21%. Those who don’t mind taking on risk in exchange for higher yields might want to consider the Janus Henderson B-BBB CLO ETF (JBBB), which has a 30-day SEC yield of 8.36% and an expense ratio of 0.49%. Both funds are in Morningstar’s “ultra-short-term bond” category, with effective durations of less than one year. Finding Opportunities According to Vishal Khanduja, co-head of broad-market fixed income at Morgan Stanley Investment Management and portfolio manager of the Eaton Vance Total Return Bond Fund (EBABX), this is a time to be discerning and consider quality. He is neutral on duration, maintains a steepening bias, and maintains an overweight to securitized credit, corporate credit, and higher-quality assets. “We are at the end of the cycle and want to be cautious about how much credit risk we have,” he said, referring to borrowers that could get into trouble if the economy softens. Khanduja is keeping an eye on commercial mortgage-backed securities, an area that is “loosely wrapped up.” One corner of this space that investors are overlooking is collateralized mortgage-backed securities (CMBS), which are tied to healthy cash flows, such as bonds from large retailers and hotels. He also likes single-family rental properties. Takeaways for Investors With the year halfway through, it wouldn’t hurt for retail investors to reassess their fixed-income allocations. Here are some guidelines to keep in mind: Beware of cash concentration: While parking money in short-term instruments can pay for now, investors who remain cash-centric risk losing interest income when interest rates fall. “A lot of younger investors are sitting on cash and are attracted to this 5% yield,” said Carrie Cox, chief market strategist at Ritholtz Wealth Management. “If the scenario of the Fed cutting rates plays out, they could miss out on another upside in the bull market.” Mind the risks: Make sure your allocation reflects your investment time horizon and risk profile. “What’s happening in the economy that’s increasing or decreasing default risk and how much spreads are widening with credit downgrades?” asks Rosen. Diversify: A mix of fixed-income assets could be needed to benefit from today’s high interest rates, lock in yields, and capture price appreciation when the Fed cuts rates. “We don’t believe you should be biased towards one fixed income asset class,” Calcagni says. “You need to have a diversified portfolio, including Treasuries, mortgages, etc.”
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