Rate Cuts and Your Bond Portfolio

After several years of low interest rates, bond yields have been attractive for the past few years. While a recent turning point in central bank policy has slightly lowered yields, today’s bond market offers a unique combination of capital preservation and income in an increasingly complex economic landscape.

Our current fixed income investment strategy is focused on positioning on the yield curve and locking in current yields as opportunities arise. The yield curve, which plots bond yields across various maturities, normally slopes upward, with longer-term bonds offering higher yields than shorter-term bonds. We can position bond portfolios to take advantage of our expectations on the level, slope, or shape of the yield curve.

In anticipation of further rate cuts, we are purchasing bonds with short- to intermediate-term maturities (approximately one to seven years) that can benefit from a “roll-down” investment strategy where we buy and then sell a bond at a higher price than purchased before it reaches its maturity date to potentially earn a higher overall return. This technique allows us to take advantage of the yield curve’s shape normalizing from a downward slope. Additionally, we are looking for attractive opportunities to extend maturities slightly to lock in current yields.

As investors, let’s review the economic backdrop that drives our strategy.

Economic Backdrop

As we approach the end of 2024, the economic landscape is defined by easing inflation and a softening labor market, providing the backdrop for the Federal Reserve’s recently initiated rate-cutting cycle. With inflation approaching the Fed’s 2% target, the Fed cut rates by 0.50% at its September meeting—a move not seen since the start of the pandemic in March 2020. In November, mixed labor market data prompted the Fed to lower short-term interest rates by another 0.25% to a range between 4.50% and 4.75%. The shift from rate hikes to cuts aims to prevent the rate increases of the prior 2½ years from weakening the labor market as inflation eases.

Given a recent uptick in several economic indicators, long-term interest rates have risen notably since the Fed’s September and November rate cuts, with the 10-year U.S. Treasury yield climbing from 3.80% to 4.30% as of mid-November. This rise reflects scaled-back expectations for future rate cuts. We expect short-term rates to stabilize around 3.50% by late 2026.

"The data-dependent Federal Reserve faces mixed economic signals."

The data-dependent Fed faces mixed economic signals. While the economy is still growing, signs of weakness may support additional cuts. For example, consumer savings rates are at historic lows while consumer debt continues to climb, and persistent geopolitical risks are elevated in the Middle East and Eastern Europe. Furthermore, the ballooning national deficit is a growing concern. With the government’s debt-service costs surpassing $1 trillion annually, the size of the deficit is expanding, potentially impacting long-term U.S. economic growth. Finally, it’s too early to say, but election-driven policy shifts could lead to significant changes in fiscal priorities, potentially increasing market volatility and reducing investor confidence.

Let’s examine how different components of the bond market are performing against this backdrop:

U.S. Money Market Funds

With interest rates elevated, short-term, relatively high-yielding money market funds have seen increased inflows as investors seek flexible, low-risk options amid economic uncertainty. This suggests that, despite the recent rate cuts, investors prioritize safety and liquidity over riskier assets. This cautious behavior likely stems from market uncertainties that include concerns about potential recessions domestically and abroad, inflation, or geopolitical risks. Money market funds offer investors relatively attractive yields compared to bank deposits.

U.S. Treasury Securities

After being inverted for over two years, the 2/10 yield curve—the difference between the 10-year and 2-year U.S. Treasury yields—finally turned positive in September 2024, signaling a potential positive shift in the economic outlook. The yield curve is inverted when the 2-year U.S. Treasury yield is higher than the 10-year yield. This unusual relationship between short and long-term rates, with investors being paid lower yields for lending money over a longer period, traditionally indicates slowing economic growth. Conversely, today’s steepening curve (positive difference) points to stronger future growth and stabilizing inflation.

U.S. Agency Mortgage-Backed Securities (MBS)

Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows (both interest and principal payments) from pools of home mortgage loans. With the end of the Federal Reserve’s quantitative easing program, wherein the Fed purchased large amounts of government bonds and securities to lower long-term interest rates and stimulate the economy, the agency and mortgage-backed fixed income markets face significantly reduced buying interest from the Fed and banks. With the Fed and banks no longer in the market for MBS securities, investment opportunities have emerged as new home loan origination rates are significantly higher than those on existing mortgages. The rise in mortgage rates affects how quickly borrowers pay off their loans early through refinancing or selling their homes. While old, lower-rate mortgages are being paid off slowly, we expect new, higher-rate mortgages to be paid off more quickly or refinanced as interest rates decline. This shifting trend could influence MBS bond performance and potentially offer investment opportunities in the agency space.

Corporate Bonds
Compared to Treasuries with similar maturities, corporate credit spreads (which represent what investors demand to be paid to take on additional credit risk) remain tight, and corporate earnings have been resilient throughout 2024. This strong performance signals potential risk, as we believe many current credit spreads do not fully compensate investors for taking on credit exposure in an uncertain economic environment.

Municipal Bonds
With larger issuance volumes in 2024, municipal bond yields have been slower to drop compared to the taxable bond market. This is particularly true for longer-dated callable bonds, which typically compensate investors more than a traditional bond because the issuer has the option to redeem the bond before it reaches maturity. Investors are rewarded for the uncertainty of when the bond will be called. California leads in municipal bond issuance, with $380 billion raised in 2024 through September—a 35% increase over 2023. This surge is driven by infrastructure, education, and capital projects, benefiting from tax-exempt bond advantages in high-tax states like California.

Where We See Opportunities

Mortgage-Backed Securities. We are targeting mortgage-backed securities with an intermediate term average life to balance stability and performance, positioning some portfolios to capture yield with AAA-rated government credit.

Corporate Bonds. Our corporate bond selections emphasize high-quality, investment-grade issuers, particularly within the financial sector, with short or intermediate maturities. Rather than relying solely on third-party credit ratings, we also perform a thorough analysis of each company’s financial position. By doing our own work, we can uncover attractive bonds in a tight-spread market.

Municipal Bonds. Depending on each client’s state of residence, our focus is on tax-exempt, investment-grade municipal bonds. We are specifically interested in those with longer maturities (for example, 10 years) and shorter callable dates (for example, four years). Additionally, we’re identifying opportunities in zero-coupon bonds to enhance yield potential while maintaining favorable tax treatment. For municipal issuers, we conduct an in-depth analysis of the municipality’s financial statements, debt levels, and economic fundamentals. This deep understanding enables us to confidently assess the ability of each issuer to meet its obligations to bondholders.

Today’s higher interest rate environment offers compelling fixed income investment opportunities to consider within a well-diversified portfolio. As always, speak with your Investment Counselor to determine whether these strategies align with your financial goals. 

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The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.