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Fixed Income: Shifting Gears

James Jackson, CFA 05-Mar-2024

hand shifting gears

What a ride the bond market has been on over the past several years. During the Federal Reserve’s historic rate-hike campaign in 2022, many fixed income investors were worried that bonds had lost their mojo. Elevated volatility was (and still might be) the new norm, and prices were under pressure as yields climbed rapidly from extremely low levels. However, as rate hikes moderated and the Fed finally paused in 2023, bonds found their footing. And late last year, fixed income markets rallied sharply as it appeared clear that we had reached the terminal rate—the peak in this rate-hike cycle.


Now, as we head deeper into 2024, investors are wondering: What’s Next? Until recently, the market (i.e., fed funds futures) was pricing in aggressive rate-cutting beginning in March. But with recent robust employment data and comments from Federal Reserve Chairman Powell, it appears less likely that the Fed will begin cutting rates imminently. Future Federal Reserve decisions will be swayed by upcoming GDP, labor market and inflation data, which is often surprising. That’s why we don’t suggest making interest rate bets when crafting portfolios. What we can do, however, is look at history, as well as the current economic backdrop, to inform an opinion and develop an action plan. Here are a few things that we see.


Despite all the rate hikes, the economy and the job market have been resilient. Recent data from the U.S Department of Labor showed that the economy added more than 350,000 jobs in January, while the unemployment rate continues to remain at historically low levels near 3.7%. All that is good news, though we still caution that the effects of our more restrictive monetary policy of the past several years can have long and variable lags, so moderating growth may not be fully reflected in the most recent economic data. While it appears that the Fed has been successfully coaxing down inflation, we also believe that the economy may slow in the months ahead.


In addition to monitoring the economy, we also look at history for some clues on how fixed income tends to perform after the conclusion of a rate-hike cycle. Based on our analysis, the end of a Fed rate-hike cycle has historically been an attractive time to add fixed income exposure. And more specifically, we see intermediate-duration asset classes outperforming their shorter-duration counterparts during these times.


Shifting to Active


If investors wish to add fixed income exposure, the next question is how to go about that. Of course, there are popular passive strategies available, but we caution investors that passive does not mean without risk. To the contrary, passive approaches may actually have more embedded risk than many investors realize. Previously, we’ve noted that the duration of the Bloomberg US Aggregate Bond Index (a popular benchmark for the investment-grade, US taxable bond market) was increasing prior to the most recent rate-hike cycle. Many investors didn’t realize that bond funds following this passive index were adding duration, which is measure of interest rate sensitivity, at the exact wrong time.


By contrast, we think that the ability to tilt a portfolio toward a manager’s preferred asset type, sector, or duration profile can be a potential risk-mitigation feature that should not be overlooked. For example, based on the current economic backdrop, we continue to remain defensive with regards to credit risk across strategies due to lingering recessionary headwinds.


In general, we see better potential in Asset Backed Securities (ABS) and Agency Mortgage-Backed Securities (MBS), in our view, relative to other fixed income asset classes. Meanwhile, corporate investment-grade and high-yield sectors look expensive, generally not offering sufficient compensation for credit risk.


If recent history has taught us anything it is that the bond market offers ample opportunity, but not without risk or volatility. We think the ability to shift between sectors and bond types is not only a key risk management tool, but also a path to potentially capturing incremental yield. Thus, we prefer the active approach, especially in this environment, as opposed to being passive about our exposures based on the makeup of existing indexes.