Investors are holding cash at a record level, with the Investment Company Institute reporting $6.1 trillion held in money market funds as of the beginning of April. Should longer-term bond yields move higher than money market rates, or if money market rates begin to move lower, the record flow into money market funds may find a new home in bonds.
How Did The Market Get Here?
Interest rates are on the rise again, with the yield on the benchmark 2-year Treasury once again approaching 5% and the yield on the benchmark 10-year Treasury pushing above 4.5%. Recent data, such as the Consumer Price Index, has not been supportive of the Fed’s desired narrative of an inflation rate on the decline.
Additionally, inflation expectations derived from swaps and bond market data are forecasting the inflation rate will remain above the Fed’s target of 2% for a while. As a result, there has been a reassessment of the future path of the Fed’s primary monetary tool, the Fed Funds Rate, by both markets and Fed officials. Market data now suggest an expectation of only two cuts for the rest of the year, down from six, and a growing number of Fed officials have taken on a decidedly dovish tone in recent weeks.
This reassessment has been the main driver for climbing interest rates, which could present an opportunity for some investors. There is the potential for a drift higher in rates over the near term and the attractiveness of staying on the sidelines, where money market funds and short-term T-bills are offering 5% or higher in yields. That said, I suggest that investors walk – not run – into bonds.
Where Is The Market Headed?
To put today’s yield environment into perspective, investors need to look at the current interest rate environment, both on a nominal and real (inflation-adjusted) basis. Yields are the highest they have been in 16 years. The attractiveness of real yields applies to non-Treasury assets as well, where, on average, high-quality corporate and municipal bond yields are above those of comparable Treasuries.
While a drift higher in future rates is a risk given the recent trend higher in inflation, the high interest rates earned in bonds now act as a cushion to help mitigate potential negative price movements. Using break-even scenario analysis, investors can estimate how high rates would have to move before adversely affecting the total return of a specific bond or bond index.
Fixed-income returns consist of two main components for most traditional bonds – price return and income return. By employing break-even scenario analysis, it’s possible to estimate the future price return of a bond using a bond characteristic called duration. A bond’s duration measures the expected change in price of a bond given the change in its yield. For example, the current 2-year U.S. Treasury bond has a duration of 1.8 years. If yields increase by 1%, then the estimated change in price is -1.8% (-1.8 multiplied by 1%).
The other component of a bond’s total return, the income or yield for that same bond, is currently 4.98% annualized. Therefore, the approximate expected total return of that bond over a one-year period, given a 1% yield increase, would be the price return of -1.8% plus the income return of 4.98%, which equals 3.18%.
Using this same analysis, investors can estimate the break-even rate movement over a defined time period, or how high rates would have to move before the expected total return of a bond is zero. When that occurs, the negative price return would exactly cancel out the positive income return, leaving a total return of zero. Any move higher in rates above that break-even level would lead to a negative total return.
As shown, interest rates would have to move higher by an estimated 1.42% before the Bloomberg Corporate Bond Index would post a negative return for a tax-exempt investor and 0.84% for a taxable investor. This assumes parallel shift in yield curves, no change in spreads, no re-investment, and no provision for state or local taxes, among other considerations. A similar move higher in rates would apply to the Bloomberg 1-10 Municipal Blend Index over the same time period at an estimate of 0.81%.
What Should Investors Consider?
For investors who are significantly underweight bonds and/or are holding excessive cash, the high yield cushion available today in high-quality bonds should provide some comfort if considering an allocation to bonds. The record $6.1 trillion in money market funds has the potential to act as an additional cushion and/or stabilizer for bond prices.
Without attempting to forecast the direction of interest rates, I’d would suggest that bond investors take advantage of the current rate environment at a measured paced – a walk, not a run.
For those underweight fixed income, the historically high real and nominal rates should not be ignored, and investors should consider reducing significant underweights. For those in money market funds, and there are a lot of you, the high money market yields of late may not remain for long, should the Fed begin to cut interest rates. Although the first cut has been pushed farther out, the general market consensus is still for the next move to be a cut, not a hike.
The suggestion here is not a significant asset allocation shift into bonds but rather a marginal increase into high-quality bonds. Each investor is unique and as such should always be mindful of specific individual specific risks, objectives, and tax considerations before any investment.
Read the full article here
