Displaying items by tag: fixed income

The rally in bonds since Fed Chair Powell’s pivot at the December FOMC meeting has been fully wiped out following recent economic data and a more hawkish than expected FOMC at the February meeting. 

Over the last month, forecasts for the timing and number of rate cuts in 2024 have been severely curtailed. Entering the year, many were looking for 6 rate cuts with the first one in spring. Now, the consensus forecast is for 3 cuts, starting in July. This is consistent with FOMC members’ dot plot at its last meeting.

The narrative is clearly changing with some chatter that the Fed may not cut at all. Prashant Newnaha, senior rates strategist at TD Securities Inc., noted that “January CPI is a game changer — the narrative that Fed disinflation provided scope for insurance cuts is clearly now on the chopping board. There is now a real risk that price pressures will begin to shift higher. The Fed can’t cut into this. This should provide momentum for further bond declines.”

Given these developments, Amy Xie Patrick, the head of income strategies at Pendal Group, favors corporate credit over Treasuries. She views the strong US economy as providing a tailwind to risky assets, while making Treasuries less attractive. 

Finsum: Bonds have erased their rally following the December FOMC meeting when Chair Powell signaled that rate cuts win 2024. Here are some of the drivers and thoughts from strategists. 

Bonds and stocks weakened following a stronger than expected January CPI report which led traders to reduce bets on the number of rate cuts in 2024. The 10Y Treasury yield climbed 15 basis points, while the 2Y yield was up 19 basis points. 

On a monthly basis, prices were up 0.3% vs expectations of 0.2%. Annually, there was an uptick at 3.1% vs expectations of 2.9%. Food and shelter prices were major contributors with gains of 0.4% and 0.6%, respectively. Along with the recent jobs report, the data undermined the notion that the Fed would be turning dovish later this year. The anticipation of a Fed pivot has been a major catalyst, fueling strength in equities and fixed income over the last couple of months. 

Instead, the status quo of ‘higher for longer’ remains. Some investors are now anticipating that the 10Y yield will rise further. According to Skyler Weinand, chief investment officer at Regan Capital, “Bond yields have not peaked, and we believe that a 10-year Treasury yield with a 5-handle is more likely than a 3-handle in 2024. Persistent inflation, full employment and strong growth may delay the Fed’s rate cuts.”

Finsum: Stocks and bonds declined as the January CPI came in hotter than expected. Fed futures showed traders reduced estimates for the number of rate cuts in 2024.

Until recently, direct indexing has typically been applied for equities. Its benefits in terms of creating after-tax alpha and increased customization are well-known. However, advisors should also be aware that direct indexing can also be leveraged for fixed income portfolios, and it can be especially impactful for clients nearing retirement. 

Direct indexing with equities means that investors own the actual constituents of an index rather than a fund. This leads to opportunities for tax-loss harvesting and personalization. Similarly, direct indexing with fixed income means that investors own the actual bonds held by a fund which also allows for tax-loss harvesting and increased personalization.

These portfolios can be optimized based on desired characteristics of credit quality, duration, and maturity. Essentially, this creates a custom, bond ladder portfolio with various fixed income securities.

Research also shows that tax-loss harvesting has more potential benefits in a fixed income portfolio. This is because there are proceeds from maturing bonds and coupons that can be used for reinvestment or lowering a cost basis. Further, the bond ladder can also be optimized based on an investors’ tax rate and/or location, to maximize accretive, after-tax returns. 

Finsum: By now, most are familiar with direct indexing for equities. Now, we are starting to see it applied to fixed income portfolios where the benefits are possibly greater. 

Two ever-present risks for fixed income investors are credit risk and interest rate risk. Rising interest and default rates diminish the value of bonds and have to be considered especially with corporate bonds. 

However, some ETF issuers now offer corporate bond ETFs with less credit and interest rate risk such as the WisdomTree U.S. Short Term Corporate Bond Fund (SFIG). It currently offers a 4.76% yield and invests primarily in short-term, corporate debt with an effective duration of 2.47 years. It’s notable that SFIG can offer such generous yields despite investing in high-quality debt with over 44% of holdings rated AA or A. 

Another potential catalyst for SFIG is when the Fed cut rates later this year. Currently, there are trillions on the sidelines in money market funds and some of this would migrate to funds with higher yields like SFIG.

According to BNP Paribas, another reason to be bullish on investment-grade corporate bonds is due to lower issuance and structurally, higher inflows. It sees less of a case for capital appreciation given the flat yield curve and recent rally, but it believes that yields at these levels are sufficiently attractive.

Finsum: Corporate bond investors have to be mindful of credit and interest rate risk. Investors can mitigate these factors with an ETF that invests in high-quality, short-term corporate debt.

Entering the year, there was considerable optimism that the Fed could begin cutting rates as soon as March. However, the February FOMC meeting, recent inflation data, and the January jobs report have made it clear that the status quo of a data-dependent Fed, prevails. It’s clear that the Fed’s next move is to cut, but timing is the mystery.

This state of affairs means that the window for bond investors, seeking value, remains open. While recent developments have been bearish for bonds, investors have a chance to take advantage of higher yields if they are willing to live through near-term volatility. This is especially if they believe the Fed will cut rates later this year which will lift the whole asset class higher. 

According to Bloomberg, “The US economy is testing bond traders’ faith that the Federal Reserve will deliver a series of interest-rate cuts this year.” Investors can buy the dip with a broad bond fund like the Vanguard Total Bond Market Index Fund ETF, or they can search for more yield by taking on more credit risk with the Vanguard Short-Term Corporate Bond Index Fund ETF. Both have low expense ratios at 0.04% and 0.03%, respectively, and have dividend yields of 3.2%.  

Finsum: Bonds are experiencing a bout of weakness due to uncertainty about the timing and extent of the Fed’s rate cuts. Here’s why investors should consider buying the dip.