How three top bond fund managers are preparing for…

One question is the extent to which long-term bond yields will fall in an economy that has remained stronger than many observers expected. This could limit the decline in yields over the long term. At the same time, if a slowdown turns into a recession, long-term yields could rise and riskier bonds – which are more expensive than safer ones – could suffer.

“Right now, the Fed has explicitly said that any moves they’re going to make are data-driven. Peters, co-chief fixed income investment officer at PGIM and one of the managers of the $47.9 billion PGIM Total Return Bond PTRQX.

Fed rate cuts on the way

It is seen as a near certainty that the Fed will announce a rate cut at its September 18 policy meeting, cutting the key federal funds rate for the first time since inflation led to the most aggressive rate hikes in history.

CME’s FedWatch tool shows futures markets predict a 64 percent chance of a quarter-point cut, while the odds of a more aggressive half-point cut are 36 percent. Just a month ago, markets were expecting just a 4% chance of a 0.5% discount. But following a weaker-than-expected jobs report that showed unemployment hit 4.3% in July (up from 3.7% earlier in the year), recession fears reignited and expectations increased for larger rate cuts.

Richard Figuly, a portfolio manager for the $47.4 billion JPMorgan Core Bond Fund JCBUX, thinks a rate cut of at least 0.25% is “on the cards” for September. He thinks it’s about a 50/50 chance whether the Fed cuts by a quarter point or a half point.

There is less certainty about where rates will be by the end of the year. Futures markets are putting a 28% change on three 0.25% cuts, a 45% chance of four, a 23% chance of five and a 4% chance of six. “We expect the Fed to cut by 25 basis points at each meeting for the rest of the year,” said Matt Brill, a portfolio manager of the $2.9 billion Invesco Core Bond Fund OPBIX.

Will the United States avoid a recession?

The key question for the bond market outlook is the trajectory of the economy. For now, data suggests economic growth has slowed. “It’s clearly a trend toward a weaker or softer labor market. But is it rolling off a cliff? No, we’re not seeing that yet. It could happen, but we’re not there yet.” , he says. Figuly.

Brill pegs the odds of a recession at 25 percent or less. He says the Fed is alert to recession risk and will take prompt action while corporate balance sheets are in good shape. “The Fed right now is kind of a bowling bumper. If something goes too far, they’ll take it back,” he says.

Peters offers a similar outlook: “we have (the chance of) a recession at 20%, which is still high, but overall a pretty decent backdrop.”

How much will yields fall over the long term?

The next question is how the intersection of economic growth and Fed policy will play out in the market. A key debate is whether to position portfolios to be more sensitive to changes in yield – a measure known as duration.

“We’re already a little overweight on duration,” Figuly says, meaning his fund is slightly more sensitive than its benchmark, the Bloomberg US Aggregate Index. The JPMorgan Core Bond Fund is also positioned to benefit more as bond prices rise, rather than falling if yields rise.

“Positive convexity acts as a duration management tool,” says Figuly, explaining that as rates fall, the fund will become more overweighted in duration relative to the benchmark. Although slightly overweight duration, the JPM fund’s main rate play is a strategy known in Wall Street parlance as yield curve tilting. The fund holds 2- and 5-year notes, but is betting that 30-year Treasury bond prices will fall. This strategy is duration neutral, meaning that the net effect of the transaction does not extend the duration of the fund. Figuly also says that if they see signs of a recession coming, the fund will want to add more duration overall.

While Peters says the PGIM fund is slightly underweight in duration, they manage this differently than the other two funds. “We separate out all the risks, so we think of duration as very different from spread risk or currency risk.” He points to the fund’s investment in AAA-rated collateralized debt obligations, which are floating rate, meaning their interest payments rise and fall with rates. This would typically mean that they are not a good investment for a falling rate environment, but by using futures contracts to remove duration risk, they can focus on CLO credit spreads (how much more yield offers above a benchmark) that they think are attractive.

Different views on credit risk

The other key variable is the degree to which the funds bet on default-risk non-US government bonds. This generally involves investment-grade corporate bonds, high-yield bonds, or other securities such as mortgage-backed bonds.

The question is whether credit yields provide enough cushion or spread over safe bonds like US Treasuries. Narrow spreads mean they offer relatively little additional return compared to historical averages. Since bond prices move in the opposite direction to yields, this means there is less room for riskier assets to rise in price.

All three managers agreed that bond spreads were quite tight, meaning that the additional return for taking on riskier assets was low compared to historical averages, resulting in lower rewards for taking on the risks.

Peters lands in the cautious camp: “we have a risk threshold for the fund and we can go to 120% of that threshold. Normally we are around 80% and we are at about 40%-45% now. The kind of upside isn’t that attractive, I’m not asking for the world to end, it’s just that as an investor I’m not getting paid for that risk.

Brill hits the middle, saying his fund is “more than six out of 10 right now” in how aggressively it invests. “We are overweight credit risk and we think it will serve as a good hedge to be a little bit overweight on duration,” he says. “There is a limited upside, but we also feel a limited downside,” he adds.

The author(s) do not own shares in any of the securities mentioned in this article. Learn about Morningstar’s editorial policies