U.S. government money market funds have seen record inflows this 12 months as their yields above 5% – the best in a long time – and lower risk status appear attractive to investors.
However, we imagine that medium-quality bonds can represent a very important and compelling option for clients’ longer-term portfolio allocation resulting from their historically high yields, longer duration profiles and potentially negative return correlation with equities and other riskier assets.
1. Yields are at a 16-year high.
Yield is usually one of the best indicator of a bond’s medium or long-term total return, and the Bloomberg US Aggregate Index (Aggregate Index) yield can provide a sexy valuation entry point for investors.
In contrast, yield is an excellent indicator of the longer-term returns of cash market funds. Finally, money market rates of interest can change every day and pose a reinvestment risk over short time horizons. Additionally, the market recently postponed major rate cuts until the second half of 2024. However, if the economic outlook deteriorates more quickly than currently expected, the Federal Reserve could cut short-term rates of interest sooner, which might further hurt money market returns.
Looking forward, we imagine investors should consider the worth that longer-dated bonds could provide in a future environment characterised by federal funds rate cuts beyond what the market has currently priced in. While money offers limited upside potential, as previous results show, the Aggregate Index could generate a complete return within the medium term that exceeds today’s return.
2. Duration has traditionally benefited from falling rates of interest.
The Fed has promised that short-term rates of interest might be “higher in the longer term.” However, if the economy slips into recession next 12 months, it could determine to chop rates of interest prior to currently expected. Total returns on high-quality bonds tended to outperform in falling rate of interest environments. Why? Partly resulting from the longer rate of interest duration profile. Money market funds, however, don’t have any significant duration risk and can hardly profit from a discount in rates of interest.
As the figure below shows, when the Fed has loosened monetary policy over the past 25 years, it has cut rates of interest quickly and dramatically. In times like these, when rates of interest exceed 5%, the speed cuts totaled 4.5% to five% over a period of about 1.5 years. The bond markets are currently forecasting key rate of interest cuts of lower than 1% over the following 1.5 years. In past Fed easing cycles, the Aggregate Index has significantly outperformed money holdings, even within the midst of the worldwide financial crisis (GFC) when credit spreads widened significantly.
When the Fed cuts rates of interest, intermediate bonds have benefited
Source: Bloomberg, as of May 5, 2023
The data represents past performance and is just not a guarantee of future results. Rate cutting cycles begin on the date the Fed cuts rates of interest and end at the bottom rate of interest in each cycle. The Bloomberg indices represented include three-month Treasury bills, five-year Treasury bills and the US Aggregate Bond Index, a measure of the US bond market. Indices are unmanaged and their returns assume the reinvestment of dividends and don’t bear in mind any fees or expenses. It is just not possible to take a position directly in an index.
In other words: In recent rate of interest cutting cycles, the typical duration of bonds tended to dominate the event of credit spreads. Once the Fed reaches its final rate of interest, longer-term yields have typically fallen as investors begin to think about lower rate of interest expectations.
10-year US Treasury bond yield after Fed pause
3. The value of the longer-term negative return correlation relationship between bonds and stocks might be precious for portfolio construction.
Historically, top quality bonds have tended to act because the “anchor” of the portfolio, providing investors with stable returns and returns which can be relatively low or negatively correlated with stock market returns. This relationship has been turned on its head in 2022. During the fastest and largest rate of interest hike cycle since 1974, bond and stock prices moved largely in lockstep and suffered historic losses. As the Fed nears its final rate of interest, we imagine top quality bonds are well positioned to resume their traditional role as a portfolio “diversifier.”
Bonds have a negative return correlation with dangerous assets
Return correlations of bonds vs. stocks
Sources: Bloomberg and Amundi US, as of September 30, 2023.
The return correlation relationship presented above highlights the precious role that bond exposure can play in reducing portfolio return volatility in comparison with money market funds. With higher yields and income, the classic 60/40 stock/bond allocation could once more develop into the dominant goal for investors.
looking ahead
With the Fed’s unprecedented rate hikes in 2022 and 2023, investors now have the chance to think about historically high yield options across the complete yield curve. While many investors understandably initially focused on money market funds in the hunt for security and yield, intermediate bonds now offer a compelling alternative in the case of the potential advantages of upper income, total return and portfolio diversification.
While the last word trajectory of the Fed’s short-term rates of interest stays somewhat uncertain, we imagine the present tightening cycle is nearing its peak and investors could also be well served by extending the duration of their fixed income exposures in response.
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Photo credit: ©Getty Images / PashaIgnatov
