Investment Strategy
1 minute read
The recent bond market rally—sparked by a disappointing jobs report on August 2—has left many of our clients wondering: Have I missed the opportunity to move out of cash and lock in longer-term yields? The short answer: No. Rates seem to be trending lower, and this trend may be just starting.
The Federal Reserve (Fed) looks poised to cut policy rates at its next meeting in mid-September (although there’s a slight chance it will act earlier). We expect the Fed to cut 25 basis points (bps)at every meeting, starting in September, with the pace of cuts slowing in the first half of 2025. In short, the U.S. rate-cutting cycle will soon be underway (several global central banks acted earlier to cut rates). History tells us that bonds typically outperform cash during these periods.
What might this mean for investors portfolio? Certain investors may consider a move from cash into longer dated fixed income securities to potentially capture future price appreciation (as bond yields fall, prices rise).
In the language of fixed income professionals, we think it’s a good time to extend duration. As a reminder, duration is a measure of a bond portfolio’s sensitivity to changes in interest rates. Extending a portfolio’s duration before rates decline causes the market value of the underlying securities to appreciate as future cash flows are discounted to a lesser extent. In other words, you need duration to benefit from falling rates. Without it, you’ll receive only coupon income from your bonds, a fraction of the total return potential in fixed income.
A strategy we recommend investors consider is a full duration position of 5–6 years that can be achieved in a 1–17 year bond ladder or mutual fund. Consider holding duration in a diversified portfolio of high-quality credit or municipal bonds. We don’t expect credit spreads to widen from current levels, and the credit premium (the extra yield over a risk-free bond) contributes valuable income, potentially boosting the total return.
This is not the first time we’ve made the case for extending duration. At various times over the past two years we have recommended considering this approach. But this seems a possibly opportune moment.
Looking at data back to the mid-1980s, extending duration one month before the first Fed rate cut instead of one month after has resulted in up to 5% greater returns over the subsequent year.1
It may be tempting to remain in cash and briefly pick up about an additional 50 bps of yield compared, say, to a strategy that tracks the Bloomberg U.S. Aggregate Bond Index, a broad bond market index with a 6.2-year duration position. However, there is a risk of missing out on potential greater returns following the first rate cut.
As always, thinking about fixed income means thinking about the Fed. Some investors worry that the Fed might be “behind the curve” in cutting rates. In their view, the weak jobs report suggests that the central bank should have cut rates at its mid-July meeting. We think the Fed looks comfortably on track to shift into a rate-cutting cycle beginning in September.
Briefly, here is why the Fed believes its March 2022–July 2023 rate hikes (the fastest hiking cycle in 40 years) has tamed inflation and cooled the economy enough to cut rates:
We do think the U.S. economy is cooling, but we assign just a 25% chance of recession over the next 12 months (up from a 20% probability in July). Remember: If the economic growth environment does deteriorate, bonds can help mitigate risks to your overall portfolio.
Our call to consider extending duration in advance of Fed rate cuts is particularly relevant for clients who retreated into cash during the 2022–2023 rate-hiking cycle. They have been earning a 5%-plus risk-free yield for over a year. Certainly holding cash helped protect fixed income portfolios from price depreciation during the hiking cycle.
But reinvestment risk is real—those risk-free yields won’t likely last. By remaining in cash, clients could miss what could potentially be in our view the most significant driver of fixed income returns since 2007. One sign the cycle is turning: Since July 1, the Bloomberg U.S. Aggregate Bond Index has returned 3.58% compared with a 0.54% return from a three-month Treasury bill index.2
You can find duration opportunities across investment grade credit, municipal bonds and government bonds. Think hard about locking in today’s yields—wait too long and they might be gone.
We can help you navigate a complex financial landscape. Reach out today to learn how.
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