With the outlook for Federal Reserve interest rate cuts today an about-face from what it was in January, now is a good time for investors to check up on their fixed income allocations. Since the start of the year, there have been signs of easing inflation – with the consumer price index holding flat in May – and a slowing job market , but policymakers have so far kept a steady hand on rates, currently 5.25%-5.50% for benchmark fed funds. Fed funds futures suggest a nearly 78% probability of the central bank easing rates in September, according to CME FedWatch . That marks a stark difference from the beginning of the year when markets anticipated six Fed rate cuts. The prospect of “higher for longer” rates has also made short-term fixed income assets especially attractive. The Crane 100 Money Fund Index has an annualized 7-day current yield of 5.13%, and total money market fund assets have grown to $6.15 trillion as of July 2, according to the Investment Company Institute . Money managers are contending with how the shift in outlook might affect their asset allocation – and they seem to be finding opportunity on the shorter end of the yield curve while gingerly adding exposure to longer-dated fixed income. “The labor markets are softening a bit, and the Fed thinks that in the future the rates will be lower, but in terms of how quickly we get there – that’s hard to predict,” said Don Calcagni, chief investment officer at Mercer Advisors. “What to do with this ambiguity?” Striking a balance Bond yields and prices move inversely to one another. Longer-dated bonds also have greater price sensitivity to fluctuations in interest rates. This is known as duration, and it’s tied to a bond’s maturity. Ahead of interest rate cuts, financial advisors have been recommending adding exposure toward longer-dated issues, which would allow investors to lock in higher yields and benefit from price appreciation as rates fall. A long periods of high rates for the past year, however, have made short-term instruments like cash, Treasury bills and money market funds even more appealing to investors. Investors who are too heavily concentrated in those investments may find that their income takes a hit as rates come down. Money managers have sought to get the best of both worlds by adding back some duration and remaining diversified across an array of fixed-income assets. “That 2- to 7-year maturity is where we are trying to position clients,” said Shannon Saccocia, chief investment officer of NB Private Wealth, a unit of Neuberger Berman. “We had a lot of investors who were in, if not cash, then sub-2-year duration fixed income at the start of the year.” Saccocia is keeping an eye on quality, with a focus on investment-grade corporates, asset-backed and mortgage-backed securities. Municipal bonds, which offer income that’s free of federal taxes, are still attractive, she said. A foot in shorter-duration assets “There are interesting opportunities and decent yields that can be had irrespective of the tight spreads we see in markets,” said Michael Rosen, chief investment officer of Angeles Investment Advisors in Santa Monica, Calif. In particular, he has been collecting solid yields from high quality collateralized loan obligations – securities that are backed by packages of loans to businesses. There’s an element of risk in that the underlying loans can be made to non-investment grade borrowers. Rosen noted that AAA CLOs are yielding more than 100 basis points over comparable corporate credit. Indeed, retail investors dabbling in the 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 who are willing to take more risk in exchange for higher yield may want to 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 are in Morningstar’s “Ultrashort Bond” category, with effective durations of less than one year. Finding opportunities It’s a time to be discerning and mindful of quality, according to Vishal Khanduja, co-head of broad markets fixed income at Morgan Stanley Investment Management and portfolio manager of the Eaton Vance Total Return Bond Fund (EBABX) . He has been neutral on duration with a steepening bias, maintaining an overweight toward securitized credit, corporate credit and higher quality assets. “We are in the late part of the cycle, and we should be prudent on how much credit risk we have,” he said, referring to borrowers who might get into trouble when the economy softens. Khanduja has an eye on commercial mortgage-backed securities – an area that is “getting painted with a broad brush.” Corners of the sector that are overlooked by investors include CMBS that are tied to healthy cash flows, including marquee retail and hospitality-backed bonds. He also likes single-family rentals. Takeaways for investors It doesn’t hurt for retail investors to review their fixed income allocation now that the year is halfway over. Here are a few guidelines to keep in mind. Watch your concentration in cash. Parking money in short-term instruments pays for now, but those who remain cash-heavy risk seeing their interest income slide when rates fall. “A lot of younger investors are sitting in cash, they are enticed by this 5% yield,” said Callie Cox, chief market strategist at Ritholtz Wealth Management. “If you get a scenario where the Fed cuts rates, you might miss another leg up in the bull market.” Be mindful of risk. Be sure that your allocation reflects your time horizon and your risk profile. “What is happening in the economy that will either increase or lower the risk of default, and how much spread are you picking up by lowering the credit quality?” asked Rosen. Stay diversified. A combination of fixed income assets may be what it takes to benefit from today’s higher rates, lock in yields and capture rising prices once the Fed cuts. “We don’t buy that there’s one fixed income asset class that you should tilt toward,” said Calcagni. “You want to build a diversified portfolio across Treasurys, mortgages and so on.”
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