Fixed income

Flexible fixed income moves for a post Fed rate-cutting regime

November 18, 2024 - 5 min read

Vice President, Portfolio Consultant – Natixis Investment Managers Solutions

The widely anticipated kickoff of the US Federal Reserve’s rate-cutting cycle caught few investors by surprise in September. But should this inflection point in Fed policy warrant rethinking your fixed income positioning?

At various points in time during the past few years, overly simplistic approaches to fixed income – including both cash-oriented and Agg-oriented (Bloomberg US Aggregate Bond Index) allocations – have proven adequate. However, the risks and opportunities have clearly shifted, and these simplistic approaches may now limit your ability to accomplish your goals over the next couple of years. So what factors should you look at to determine whether a new approach is needed? There are three key points to consider when answering this question today: avoiding reinvestment risk, limiting concentration risk, and diversifying across multiple macroeconomic paths.

1. Protect against reinvestment risk

Cash returns can change quickly. The Fed’s 50 basis point cut in September was a great reminder of this. Looking out at expectations for the Fed funds rate over the next few years offers a good sense of the market’s expected path of cash. The 5.0%+ return days appear to be over. Cash expectations over the next two years are just 3.9%, and over five years, just 3.4%.1 Investors with time horizons greater than a year or two should take special note of this.

It may feel like a lot of cuts are already priced in, and the market may have gotten ahead of itself. But historically, cutting cycles have been sudden and steep around recessions and a bit more measured during midcycle adjustments. Without knowing for certain which type of environment we’re heading in to, the market has anticipated somewhat of an average between the two. Having too high of a cash allocation at the start of a cutting cycle creates reinvestment risk. Staying in cash as rates are falling means missing an opportunity to lock in higher returns over multiple years.

Effective Fed Funds Rate

Source: Natixis IM Solutions, St. Louis Fed

2. Avoid Agg concentration

At the other end of the spectrum, the Agg investor is protected from reinvestment risk but is exposed to drawdowns from more concentrated bets. This index comprises only half of the US fixed income universe, meaning you are missing out on diversifying exposures in other fixed income segments. Investing in the Agg is making three highly correlated bets on the US Treasury bond market, agency mortgage-backed securities, and US corporate bonds. Moreover, the proportion of US Treasuries has steadily increased over the past several years, increasingly making the Agg a play on Treasury yields.

Bloomberg US Aggregate, Treasury Allocation

Source: FactSet, as of October 17, 2024

A more robust fixed income sleeve with greater differentiation from the Agg can provide more opportunities for both return enhancement and risk mitigation. If the goal is to maximize risk-adjusted returns, you want more levers in your portfolio that can be used for either return enhancement or risk mitigation. This includes plus sectors like broader securitized categories, high yield, bank loans, and collateralized loan obligations (CLOs). It can also include more defensive exposures like floating rate securities, Treasury Inflation-Protected Securities (TIPS), and certain currencies.

3. Diversify to outperform in different types of environments

For duration-sensitive strategies, the path to outperform broader fixed income via price appreciation from falling yields has narrowed. But the starting point was particularly attractive, and the case for duration has gone from great to good. Still, overly relying on outperformance from falling yields may be too limited of an approach. Thinking about the directional possibilities of Treasury rates and credit spreads, the Agg investor is positioned to outperform only in lower-rate environments. Meanwhile, the cash investor is positioned to outperform broader fixed income only in higher-rates and spread-widening scenarios.

How do you still do well in range-bound yield environments? How do you add value in tight spread environments that might stay tight for a while?

Solution: Broaden your opportunity set

Hold the short end of the yield curve for lower volatility and better risk-adjusted returns. Hold the intermediate/long end for equity-risk offset. And hold both for both.

A core-satellite approach with a core-plus core and a lower duration, more flexible satellite (such as nontraditional or multi-sector bond) gives you a “core plus plus” profile that can more effectively target outperformance in different scenarios. The combined exposure from this type of construct diversifies exposure across the yield curve. It also provides more levers for active management, avoiding the benchmark-aware approach that has become a concentrated bet on rates falling. It allows you to be more selective with credit selection in a tight spread environment and helps to avoid needing dedicated strategies for several niche fixed income categories that can create line-item risk and make the portfolio more difficult to manage.

Overall, the core piece gives you enough of the high-quality duration poised to outperform in a growth scare and in a midcycle policy recalibration. The satellite’s lower duration and slightly higher credit quality vs. high yield and many multisector strategies may benefit relative performance in a range-bound or slightly higher interest rate environment – particularly in one where spreads drift modestly higher. Finally, the additional flexibility that you’ve attained can add value across fixed income segments, regardless of the cycle.

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