Fixed income investors may want to consider making some adjustments to their investment portfolio as the second half of the year begins. Despite previous expectations of multiple rate cuts this year, the Fed kept the federal funds rate steady at a range of 5.25% to 5.50%. But the central bank is expected to start lowering interest rates in the coming months, perhaps next September. At its last meeting in June, the Fed indicated only one cut before the end of the year. However, many on Wall Street still believe two cuts are likely this year, including Charles Schwab. “There is room for them to cut interest rates because inflation is falling… (and) the labor market is cooling down,” said Cathy Jones, chief fixed income strategist at Charles Schwab. She added that price and jobs market data are close to the Fed's targets and that real interest rates, after inflation, remain high. Jones expects better fixed income returns in the second half but believes volatility will remain high. Finding the right mix of fixed-income asset classes will be key to performance, she said. Look to Add Some Duration In this environment, Jones will start to think about adding some duration – in other words, exiting to longer maturities. “Look beyond Treasuries,” she said. She explained that although it remains an essential holding, the potential gains from higher rates appear limited as the yield curve remains inverted, that is, when short-term interest rates are higher than those paid on long-term securities. In fact, there is plenty of opportunity to get 5% returns in the medium and long term without taking on significantly more credit risk, Jones said. It specifically likes investment-grade corporate bonds, government agencies, and mortgage-backed securities in the six- to seven-year time frame for attractive yields and potential price appreciation. “We know spreads are tight (in investment-grade bonds), but we don't see a major default cycle starting any time soon… where we're concerned about a loss of capital or a major downgrade in credit ratings,” Jones said. She suggested that investors could have an ironclad portfolio with Treasuries on one side, and investment-grade bonds and MBS on the other. They could also opt for a bond ladder, filling the middle rungs of the ladder with investment-grade companies and agency MBS, she said. JPMorgan also likes the iron approach. The bank expects the yield curve to remain inverted through the end of 2024, but said the curve could slope positively by the end of 2025. Benchmark 10-year Treasuries are currently yielding 4.259%, while one-year Treasuries are yielding less than 5%. . . History shows that if a combination of looser monetary policy and/or slower growth and inflation allows the curve to steepen, gradually extending duration serves investors better, JPMorgan said in its mid-year outlook. “However, the shallow path of interest rate cuts driven by normalization of growth and inflation suggests that investors may be better suited to adopt a barbell approach by generating returns that remain attractive on the front end while having some duration as a portfolio hedge,” the team wrote. Meanwhile, Wells Fargo is calling on investors to prioritize credit quality as the yield curve remains inverted over the next six to 18 months. “If this whole story ends in some ways with more economic pain before the Fed comes to the rescue, you want to improve the quality of your portfolio,” explained Samir Samana, chief global market strategist at the Wells Fargo Investment Institute. Currently, Wells Fargo favors municipal bonds and securitized products, such as residential mortgage-backed securities. It finds high-quality residential real estate loans, including agency and non-agency mortgages, attractive because of their relative value compared to investment-grade companies. Meanwhile, Muni bonds are a good investment for those in the highest tax bracket because they are free of federal taxes, Samana said. “Given all the talk about deficits and fiscal responsibility, it's possible we could see a scenario where at some point tax rates have to go up for more fiscal discipline,” he said, adding that wouldn't happen anytime soon. Within municipalities, Wells Fargo favors state and local overhead obligations and essential services revenues.
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How Wall Street Fixed Income Plays in the Second Half of the Year
