The financial landscape has been swiftly evolving, especially in the realm of interest rates. As Registered Investment Advisors (RIAs) and wealth advisors, it's crucial to understand these shifts to better advise clients. The swift drop in the 10-year Treasury note yield from 5% to 3.9%, along with the Federal Reserve's indication of potential rate cuts, presents a unique opportunity for fixed-income investments.
Many investors, now used to 5% yields, may feel pressured to quickly move into bonds with longer maturities. However, there is still ample opportunity to secure attractive yields. As Kathy Jones, Chief Fixed-Income Strategist at Charles Schwab, advises, locking in 4% yields for the medium term is a strategic move, especially considering the potential for reinvestment risks and lower future rates.
It's a balancing act: maintaining high-yielding cash positions while strategically extending into longer-term maturities to optimize returns and mitigate risks. Michael Arone from State Street Global Advisors highlights 2024 as a pivotal year when reinvestment risks may become a significant concern.
A key strategy involves capitalizing on potential bond price gains when interest rates decrease, as bond prices and yields move inversely. Extending bond maturities in anticipation of the end of the Fed's tightening cycle is advisable, despite the challenges of timing the market amidst rate volatility.
Understanding duration – a measure of a bond's sensitivity to interest rate changes – is critical. Investments with higher durations stand to gain more if rates fall. For instance, a bond fund with an effective duration of six could potentially see a 6% gain if rates drop by one percentage point.
Janet Rilling, head of the Plus Fixed Income team at Allspring Global Investments, underscores the importance of adding duration before rate cuts. Tactical adjustments between neutral and long durations are key, as exemplified by the Allspring Core Plus Bond Fund, which has effectively managed its duration to capitalize on potential rate decreases.
Extending a fixed-income portfolio's duration can be challenging, especially with an inverted yield curve where long-term rates are lower than short-term ones. Kathy Jones recommends a "lopsided barbell" approach, balancing short-term maturities with selective longer-term investments, like 10-year Treasuries.
Investors should be cautious about taking on excessive credit risk, especially in an environment indicating a potential recession. While high-yield bonds like the SPDR Bloomberg High Yield Bond ETF may seem attractive, the risk-reward balance is not always favorable.
Diversifying into preferred securities and U.S. agency mortgage-backed securities offers an alternative. Preferred securities, especially those issued by large, highly rated banks, provide attractive yields and tax advantages. Meanwhile, agency mortgage-backed securities, with implicit government backing, offer low default risk and extended durations due to current mortgage holding patterns.
Active management in diversified core bond funds can also play a significant role in effectively managing duration with professional oversight. Funds like the SPDR DoubleLine Total Return Tactical ETF, managed by Jeffrey Gundlach, demonstrate the advantages of active management in a tight credit spread environment.
Closed-end bond funds are another avenue, often trading at a discount to net asset value and offering substantial interest-rate exposure. These funds typically focus on higher-rated municipal bonds and extend effective durations.
In summary, RIAs and wealth advisors should advise clients to balance their fixed-income portfolios with a mix of strategies. While it's not necessary to exclusively focus on long-term bonds, a well-considered blend of cash, short, and longer-term maturities can optimize returns and mitigate risks in the current evolving interest rate environment.
