NEW RATE REGIME
While the money and bond markets wonder what higher for longer will actually mean, the more accurate way of looking at fixed income is that it has entered into a new rate regime. The end result of this rate hike cycle will be that interest rates are now at levels a generation of investors have not witnessed before, ushering in a new “old” rate regime, one that harkens back to pre-financial crisis times. Against this backdrop, investors have a whole new dynamic to consider in their fixed income portfolio decision-making process.
Duration
The biggest question on investors’ minds for next year is when and how to extend duration. Have we reached the point to begin this trade? And if so, how could investors go about doing it?
One approach is to extend duration in a deliberate fashion and not try to go all at once and “market-time” the trade. This approach can be accomplished by moving closer to the core benchmark. The vast majority of investors have been short, or under-weight in, duration to their benchmarks for quite some time. So, in our opinion, investors should consider getting closer to neutral to the benchmark in their overall fixed income positioning.
We believe, within that broader framework, the barbell approach would certainly represent a solution to achieve a fixed income investor’s duration target. As previously mentioned, Treasury floating rate notes could act as one of the “weights,” while on the other end of the barbell, something more core or core-like could be appropriate. Investors would then be able to toggle back and forth, given their rate outlook, to achieve the bond positioning and income they need. Utilizing this strategy, you don’t need to put all of your bets down on the longer end of the curve and make a ‘call’ on where you think the 10-Year Treasury yield will be. The barbell strategy can help extend duration while also being mindful of the yield curve and how it’s still inverted.
The Yield Curve
Yield curve inversion was all the rage a year ago, so the next key question for the money and bond markets is whether we think the Treasury yield curve can go back into positive territory in 2024. First off, a lot will depend on the outlook for the Fed. If we get the forward guidance from the Fed that the policy maker is going to start cutting rates, then the steepening trend we’ve seen throughout the autumn months would probably take on another head of steam.
In our opinion, there are pressures at both ends of the curve that are favoring a potential re-steepening. Obviously, the Fed lowering rates is the first consideration. In addition, increased supply due to baseline trillion-dollar deficits could have more of a painful effect on the long end of the curve.
Credit vs. Rates
As an investment committee (in our model portfolios), we have been over-weight in credit versus rates. Do we continue with that into 2024, and what are our thoughts about high yield? There’s still some value and carry left in the investment-grade space, but you should be more selective in high yield.
It’s directly linked to the magnitude of the slowdown we see in the economy and the responsiveness of the Fed. We think you will benefit from carry. Given where rates are, you’re still getting roughly 25% additional yield by being in investment-grade credit. In high yield, one should be more selective. It will be important to see positive cash flow because default rates could rise further from current readings.
Interest rates are now at levels a generation of investors have not witnessed before, ushering in a new “old” rate regime.
Figure 3: U.S. Fixed Income Yields
CHART TAKEAWAY: While the money and bond markets wonder what higher for longer will actually mean, the more accurate way of looking at fixed income is that it has entered into a new rate regime. The end result of this rate hike cycle will be that interest rates are now at levels a generation of investors have not witnessed before, ushering in a new ‘old’ rate regime, one that harkens back to pre-Financial Crisis times.
Source: Bloomberg, as of 12/12/2023.
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