How to position your short-term bond portfolio…

With the Federal Reserve embarking on a rate-cutting cycle and a soft landing looming, investors expect short-term interest rates to drop quickly. On Friday, after the Consumer Price Index showed inflation at 2.2% in August — a staggering distance from the Fed’s 2% target — bond futures markets began to price in another dramatic interest rate cut of half a percentage point for November. This would follow an easing of the same magnitude by the Fed in September.

Here’s everything investors need to know about the rapidly changing bond market landscape.

What is the yield curve?

The yield curve is a graphical representation of government bond yields at various maturities, most commonly from the two-year Treasury to the 10-year Treasury.

For the most part, bonds with longer maturities yield more than bonds with shorter maturities. That’s because investors expect additional compensation for the risks – such as inflation and economic uncertainty – of locking their money with the government for longer. The result is an upward sloping curve.

In rarer circumstances, short-term yields rise more than long-term yields, resulting in an “inverted” downward-sloping curve. This happens when investors anticipate slower economic growth in the future and therefore lower interest rates going forward. It is often interpreted as a signal of a recession.

The yield curve inverted in 2022 and remained so until recently, when long-term yields narrowed over their short-term counterparts.

“We’ve been significantly reversed for a significant period of time,” explains Dominic Pappalardo, chief multi-asset strategist at Morningstar Investment Management.

This has created an unusual dynamic in the bond market, he notes. Because investors didn’t have to take on the extra risk associated with long-term bonds to get higher returns, he says, “you probably ended up with this artificial overweighting by investors on the short side of the yield curve, because that’s where it was.” where the most income was available.”

Why was the yield curve normalized?

As it became clear to investors late this summer that the Fed was ready to cut interest rates, yields on short-term bonds — which closely track the central bank’s target interest rate — began to fall.

Longer-dated bond yields — which track expectations about the state of the economy and the path of fiscal policy going forward — also fell, but not as dramatically. When the two-year bond yield fell below the 10-year in early September, the yield curve did not officially invert.

While there has been extensive debate over whether the inversion of the yield curve — or its non-inversion — are signs of recession, there is a simpler message that investors can take from the shift.

Matt Diczok, Head of Fixed Income Strategy for the Chief Investment Office at Merrill and Bank of America Private Bank, explains: “The normalization of the yield curve tells you what we already know: The Fed is ready, willing and able to provide more money. policy accommodation, provide more liquidity and offer lower rates to keep the economy on a better footing.”

He adds that recession or not, this message means the yield curve is still a useful indicator for investors. “He said the economy would slow dramatically, and it did.”

Cash is no longer a free lunch

Falling short-term yields mean the comfortable returns that investors have enjoyed in cash and very short-term products like money market accounts will also fall. As this happens, strategists expect the crowd of investors at the short end of the curve to begin to thin.

“The fact that the curve is no longer inverted means you’re not earning more cash yield than you are further along the curve,” says Patrick Klein, a portfolio manager for Franklin Templeton’s multi-sector and quantitative fixed income. strategies.

Bank of America’s Diczok says he reminds clients that a flattening yield curve is a good time to consider adding longer-dated bonds to a portfolio and moving away from cash.

“If you’re buying cash when it’s very high-yielding, that’s usually right before the Fed tapers and your future returns are going to be pretty weak,” he says, which is why it makes sense to build a portfolio with term bonds longer to protect against macroeconomic risk. and lock in reliable returns.

“Cash is not fixed income, it’s variable income,” says Diczok.

“Fixed income investors generally will move off the curve as the front end declines,” adds Klein.

The yield curve is expected to slope

As of Sept. 26, the 10-year Treasury was yielding 3.79 percent, while the two-year was yielding 3.60 percent — a gap of 0.19 percentage points.

Strategists expect the spread between the two bonds to continue to widen as the Fed cuts rates, which will push yields at the short end of the curve lower until the central bank hits the “terminal” rate — the end of the easing cycle . With a soft landing with prices in the economy, they say yields at the longer end of the curve are not likely to fall much from current levels, if at all.

This is what bond traders refer to as a “bull run” – when yields at the short end of the curve fall faster than yields at the long end. Meanwhile, prices for both assets are rising. (Bond yields and prices tend to move in opposite directions.)

A bearish tilt, on the other hand, occurs when longer yields rise faster than their shorter counterparts. This is a rarer scenario and generally means investors are wondering if the Fed is behind the curve, Diczok explains. “Inflation could be accelerating … (it’s) certainly a more worrisome and unusual event.”

Risks for investors

It’s a nuanced concept, but the type of tilt “makes a big difference,” for investors and especially for those looking further along the curve, Franklin Templeton’s Klein says. The bull run is driven by a rise in shorter-dated bonds, meaning yields are falling while prices are rising. But if those declines are driven by growth concerns, Klein says, investors could see riskier holdings like stocks.

Strategists say further bearishness is possible – a future selloff in longer-dated bonds as shorter-dated bonds remain more predictable. A soft landing isn’t guaranteed, and “there’s room for the long end to go up,” says Klein.

“We actually think the market is a little too bullish on the probabilities of a soft landing.”

Long-term rates may also rise as the government deficit grows, especially as the economy has shown it can withstand higher interest rates across the board, and strategists also say long-term bonds could see some volatility in the coming months.

“With government spending unlikely to slow regardless of the election outcome and US debt already breaking new highs every month, there is a precedent for rapid rate swings at the long end of the curve – an unfavorable risk/reward profile,” they wrote strategies from BlackRock within them. the latest perspective.

And with rates falling across the board, Diczok cautions investors against grabbing income anywhere they can find it. On the corporate side, he favors investment-grade credit over riskier, high-yield deals.

The bottom line for bondholders

As the yield curve continues to normalize, Klein says the best place for investors “really depends on what you’re trying to achieve with that fixed income allocation.”

While strategies encourage investors—especially those with extra cash—to look further up the yield curve with their portfolios, the sweet spot will vary based on an individual’s goals and risk tolerance.

As a starting point, Diczok recommends sticking with the crowd. The average duration — a measure of interest rate risk that is tied to a bond’s maturity — in the fixed-income market is about six years, and he says that’s a good place to start. “Unless you have a very good reason not to be around six, you should be around six,” he says.

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