Don’t get too short(sighted) in fixed income
Many investors are trying to precisely time interest rate movements. We believe this approach is more of a gamble than a fixed income strategy. Some investors have gone so far as to invest a large portion of their assets into money market funds / short-term Treasuries/CDs. While an unknown number of additional Fed Funds rate hikes appear likely on the docket for 2023, the current Fed tightening cycle is well past the mid-way point with a Fed Funds rate currently at 5-5.25%.
Currently, the market is already pricing in another Fed Funds hike to 5.25-5.50% at the July meeting (in late July) versus February 2022 at 0-0.25%. To put this forecast into perspective, the Fed’s “Summary of Economic Projections” as of June 2023 points to a Fed Funds Rate of 3.4% in 2025 and 2.5% over the longer run. Even if inflation remains elevated in the near-term, requiring the Fed to hike more aggressively, ultimately the Fed Funds is very likely to decline. Therefore, over the next few years the risk is skewed to the downside for the Fed Funds rate. The Fed is extremely motivated to ensure this happens because a Fed Funds rate persistently over 5% means inflation has not declined anywhere close to the Fed’s 2% inflation goal.
While the path of inflation’s decline remains uncertain, two possibilities appear most likely. Either inflation fades slowly until 2% inflation appears on the horizon, or an even higher interest rate environment causes a recession. A slow inflation fade scenario would likely coexist with an elevated Fed Funds rate for longer, while a recession would likely lead to an abrupt inflation decline. Ultimately, the depth and length of a recession will determine just how low inflation goes and, correspondingly, the amount of subsequent Fed Funds rate cuts required to stabilize the economy. If the Fed Funds rate stays elevated for longer than the Fed’s current expectations, a fixed income portfolio could simply reinvest in such an environment. However, in the abrupt recessionary scenario, interest rates will likely decline quickly and investors owning short-dated instruments will have missed the opportunity to lock in the current yield opportunities.
At this point in the Fed tightening cycle, an intermediate duration (interest rate sensitivity) fixed income portfolio will likely deliver a higher total return than staying invested in very short-dated money market funds, short-term Treasuries, or CDs. We illustrate the significant reinvestment risk many investors appear to be ignoring with a simple example. Based on the Fed’s “Summary of Economic Projections” as of June 2023, the Fed Funds rate, which is a good proxy for money market funds before fees, is estimated to average approximately 4.0% annually over the next four years. This compares to the intermediate corporate bond index which yields approximately 5.4%, or nearly 1.4% per annum higher. This additional yield provides significant cushion for the potential divergence of the future from the Fed’s June 2023 forecast.
As the market now finally believes what the Fed has been consistently stating for months (that the Fed will likely not cut rates in the near-term), interest rates across the Treasury curve have risen. This has provided an attractive opportunity for those in ultra short-dated fixed income securities to consider owning a moderate amount of duration. With intermediate corporate bonds yielding approximately 5.5%, an investment grade fixed income portfolio with a duration of four years or less has significant cushion to absorb potential increases in Treasury yields (and the resulting decrease in bond prices) and still generate a positive 12-month return. Investment grade corporate bond yields are near their highest levels in over a decade.
Investment grade bond yields
We also want to remind investors who own individual bonds that the duration of a security declines over time because the maturity gets closer. This may require investors to sell their short-dated securities to reinvest in longer-maturity securities which will benefit when interest rates do eventually decline. For example, a 1-year 5% bond would not benefit nearly as much if Treasury rates (interest rates) decline as would a 5-year 5% bond.
Regarding duration (interest rate sensitivity): at the extreme end of low duration, money market funds do not benefit one iota when overnight interest rates eventually do decline. To make prospects worse, the yield upon reinvestment instantly declines. We also would advise against the other duration extreme of buying exclusively very long-dated bonds. Long-dated bonds are exposed to market expectations over many economic cycles both domestically and globally. Also, long-dated U.S. Treasury yields can be heavily influenced by the competitiveness of U.S. rates versus global rates. An intermediate duration portfolio, by contrast, will benefit from the eventual decline in the Fed Funds rate (overnight) without being overly exposed to long-term rates. Furthermore, a portfolio focused on intermediate bonds (2-7 years) will disproportionally benefit from the Treasury yield curve eventually normalizing (versus being currently inverted). We think investors sitting on excess cash, money market funds, and short-term Treasuries/CDs would be well served by switching to an intermediate duration, actively managed fixed income portfolio.
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