By Ivan Gruhl
Avantax Co-Chief Investment Officer
In this recent market, where short-term yields are the same or higher than long-term yields, some investors have replaced model bond portfolios with cash. Many are questioning the role of fixed income when cash can yield the same amount or more. Despite current higher short-term rates, we believe it is a more prudent long-term strategy to invest in a diversified bond portfolio. The current environment is favorable to invest in a broad-based model portfolio from a total return perspective, as well as to take advantage of manager expertise. When constructing a bond portfolio, an active fixed-income manager can incorporate views on interest rates, the market, and the economy. Variables such as yield-curve positioning, credit quality, and interest-rate sensitivity (duration) exposure can reduce risk and take advantage of developments as market conditions change.
Remember, the Fed was holding the federal funds rate at around zero as recently as the first quarter of 2022, as well as buying billions of dollars of bonds every month to stimulate the economy. Once the Fed decided it was time to do something about inflation, it moved forcefully, raising the fed funds rate by more than five percentage points to the current range of 5.25%-5.50%. The 10-year Treasury note, which yielded 0.6% in August 2020, rose to a yield of 5.0% by October 2023. Short-term rates rose as well, with the 3-month Treasury bill trading in a range of 4.3% to 5.3% throughout 2023. The bottom line: fixed income investors finally saw income return to their portfolios. While cash or a CD may provide an attractive yield today, that yield will decline over time if market expectations for rate cuts are realized, and short-term rates fall. A portfolio of bonds, on the other hand, will maintain income through its coupon while providing attractive total returns as holdings in the portfolio appreciate.
To provide a simple example, the total return on a bond or portfolio of bonds is a function of the income it generates plus or minus any change in price. Change in price is a function of the duration of a bond and the amount of change in the bond’s yield. Let’s suppose an investor holds a bond portfolio yielding 5% with an average maturity of about 10 years. This would give the portfolio a duration of about six years, close to the market duration. If rates fall 50 basis points (to a yield of 4.5%) over a year, the total return would be approximately 8%, consisting of the 5% coupon plus the price appreciation of 3% (0.50% x six-year duration). If rates rise, the higher level of income acts as a cushion, and the bond will still have a positive return of about 2%, with further potential for additional price appreciation if rates fall in the future. An investor not only enjoys a higher level of income but also the potential for capital appreciation. If an investor anticipates interest rates will fall, having exposure to longer-duration securities will provide additional return to portfolio. With cash and money market funds, as interest rates fall, there is no price appreciation, and investors are forced to accept lower interest rates as they roll their short-term investments forward. This is what is called reinvestment risk, that is the possibility that an investor will not be able to reinvest cash flows from an investment at a rate equal to or higher than the investment's original rate of return.
As indicated by data from FedWatch, futures markets are pricing in several rate cuts over the remainder of 2024, and we believe the next move in rates will be down. With the potential for an economic slowdown and uncertainty in markets, we believe long-term investors should take advantage of this environment to invest in a diversified portfolio of bonds.
Sources: Madison Investment, Forbes