With the prospect of a rate cut from the Fed today looking very different than what happened in January, now is a good time for investors to review their fixed income allocations. Since the start of the year, inflation has shown signs of easing (CPI was flat in May) and the job market has slowed, but policymakers have so far kept interest rates steady, currently at 5.25%-5.50%. According to CME FedWatch data, federal funds futures show that the probability of the central bank cutting interest rates in September is close to 78%. This is in sharp contrast to market expectations at the beginning of the year that the Federal Reserve would cut interest rates six times. The prospect of “higher longer” interest rates also makes short-term fixed income assets particularly attractive. According to the Investment Company Institute, the current seven-day annualized return of the Crane 100 Money Fund Index is 5.13%, and as of July 2, total money market fund assets have grown to $6.15 trillion. Fund managers are pondering how the shift in outlook might affect their asset allocations – they appear to be looking for opportunities at the shorter end of the yield curve while cautiously increasing exposure to longer-dated fixed income. “The labor market is softening a little bit and the Fed thinks interest rates will be lower in the future, but in terms of how quickly we get there, it’s hard to predict,” said Don Calcagni, chief investment officer at Mercer Advisors. “In the face of this ambiguity, What to do? ” To reach equilibrium, bond yields and prices move inversely. Bonds with longer maturities also have greater price sensitivity to interest rate fluctuations. This is called duration, and it’s related to the bond’s maturity date. Prior to the rate cut, financial advisers had been recommending increased investments in longer-term bonds, which would allow investors to lock in higher yields and benefit from price appreciation when rates fall. However, high long-term interest rates over the past year have made short-term instruments such as cash, Treasury bills and money market funds more attractive to investors. Investors who are too concentrated in these investments may find their income takes a hit as interest rates fall. Fund managers try to get the best of both worlds by adding a certain duration and maintaining diversification across a range of fixed-income assets. “We try to position clients on maturities of two to seven years,” said Shannon Sacccocia, chief investment officer at Neuberger Berman’s NB Private Wealth. “At the beginning of the year, we had a lot of investors in fixed income investments with maturities under two years, if not cash. ” Saccocia has always focused on quality, focusing on investment-grade corporates, asset-backed and mortgage-backed securities. Municipal bonds, which offer federal tax-free income, remain attractive, she said. Dab into short-term assets “Even though we are seeing tight spreads in the market, there are some interesting opportunities and substantial gains,” said Michael Rosen, chief investment officer at Angel Investment Advisors in Santa Monica, Calif. . There is an element of risk that the underlying loan may be made available to non-investment grade borrowers. Rosen noted that AAA CLO yields are more than 100 basis points higher than comparable corporate credit. In fact, retail investors involved in this space can participate 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 willing to take on more risk in exchange for higher returns might 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 fall into Morningstar’s “ultra-short-term bond” category, with maturities of less than a year. Finding Opportunities Vishal Khanduja, co-head of large market fixed income at Morgan Stanley Investment Management and portfolio manager of the Eaton Vance Total Return Bond Fund (EBABX), says now is the time to be discerning and focused. When it comes to quality. He is neutral on duration with a steepening bias, maintaining an overweight position in securitized credit, corporate credit and higher quality assets. “We are in the late stages of the cycle and we should be cautious about the credit risks we face,” he said, referring to borrowers who may find themselves in trouble when the economy weakens. Khanduja looked at commercial mortgage-backed securities — an area “that’s being mapped out on a massive scale.” Corners of the industry that have been overlooked by investors include CMBS tied to healthy cash flows, including large retail and hotel-backed bonds. He also likes single-family rentals. Investor Takeaways Now that we’re halfway through the year, it doesn’t hurt for retail investors to take another look at their fixed income allocations. Here are some guidelines to keep in mind. Note the concentration of cash. For now, it pays to keep money in short-term instruments, but those who still hold large amounts of cash may be at risk of falling interest income when interest rates fall. “A lot of young investors are holding cash, and they’re attracted by the 5% yield,” said Callie Cox, chief market strategist at Ritholtz Wealth Management. “If there’s a Fed rate cut, you might miss another bull market rally. ”Be aware of the risks. Make sure your allocation reflects your time horizon and risk profile. “What’s happening in the economy that increases or decreases default risk, and how much does that increase in spreads by lowering credit quality?” Rosen asked. Stay diverse. Fixed income portfolios may be in a position to benefit from the current higher interest rates, lock in yields and capture price increases should the Fed cut interest rates. “We don’t believe you should invest in one fixed-income asset class,” Kalkani said. “You want to build a diversified portfolio across Treasuries, mortgages, etc.”
