Entering the year, there was considerable optimism that the Fed could begin cutting rates as soon as March. However, the February FOMC meeting, recent inflation data, and the January jobs report have made it clear that the status quo of a data-dependent Fed, prevails. It’s clear that the Fed’s next move is to cut, but timing is the mystery.
This state of affairs means that the window for bond investors, seeking value, remains open. While recent developments have been bearish for bonds, investors have a chance to take advantage of higher yields if they are willing to live through near-term volatility. This is especially if they believe the Fed will cut rates later this year which will lift the whole asset class higher.
According to Bloomberg, “The US economy is testing bond traders’ faith that the Federal Reserve will deliver a series of interest-rate cuts this year.” Investors can buy the dip with a broad bond fund like the Vanguard Total Bond Market Index Fund ETF, or they can search for more yield by taking on more credit risk with the Vanguard Short-Term Corporate Bond Index Fund ETF. Both have low expense ratios at 0.04% and 0.03%, respectively, and have dividend yields of 3.2%.
Finsum: Bonds are experiencing a bout of weakness due to uncertainty about the timing and extent of the Fed’s rate cuts. Here’s why investors should consider buying the dip.
In 2023, yields started where they ended, although there was considerable volatility in between. Notably, yields dropped sharply following the collapse of Silicon Valley Bank in the spring amid concerns that it would spark a greater crisis. And, yields spiked in autumn with the 10-year Treasury yield exceeding 5% following an uptick in inflation.
In hindsight, this marked the bottom for fixed income as the Bloomberg U.S. Aggregate Index gained nearly 10% between the end of October and the new year. Looking ahead, Vanguard believes this strong performance will continue in 2024.
In terms of its outlook, it sees inflation ending the year just above the Fed’s 2% target. It believes the Fed will ease policy, although they don’t see rates returning to the same lows as the previous cycle. It also sees the yield curve steepening as short-term rates fall further.
The firm also acknowledges some risks to its outlook such as the economy continuing to be bumpy even within the context of a slowdown which could lead to false signals. Credit spreads have remained tight which means that there is greater risk in the event of a recession. High deficits mean that Treasury supply will be plentiful, adding upwards pressure to yields. Finally, inflation could re-ignite especially given geopolitical risks and prevent the Fed from easing even if the economy warranted it.
Finsum: Many active fixed income funds are being launched with a specialized focus on a particular niche. These funds have outperformed amid the volatility in the fixed income market.
For income-seeking investors, navigating the often volatile capital markets can be a tightrope walk between yield and stability. Enter income-producing ETFs, a potent blend of diversification and dependable returns. These innovative funds package high-yielding assets into a single, tradable security, offering investors a steady income stream without the burden of individual security selection.
One of the key strengths of income-producing ETFs lies in their inherent diversification. By spreading investments across a basket of assets, they mitigate the risks associated with individual maturities or underperformance. This eliminates the headache of reinvesting maturing bonds at potentially lower rates, a common pitfall for fixed-income investors.
Furthermore, income-producing ETFs typically hold less cash than their mutual fund counterparts. This seemingly minor distinction translates to a potentially significant advantage: reduced cash drag. Unlike mutual funds, which often require a cash cushion to facilitate redemptions, ETFs minimize uninvested capital, ensuring a greater portion of your portfolio actively generates income within its intended asset class.
Financial advisors seeking to craft reliable income streams for their clients should consider income-producing ETFs as a possible solution. They provide instant diversification, mitigate reinvestment risk, and maximize income potential through reduced cash drag.
Finsum: Income-producing ETFs can provide both diversification and steady returns with reduced reinvestment risk and cash drag.
The era of high yields has led to a significant boost of inflows into fixed income ETFs. Last year, short duration bond ETFs were the biggest recipient of inflows, but this started to change at the end of last year. Inflation started to move closer to the Fed’s 2% target, and the market began to price in rate cuts in 2024.
So, investors have been moving further out in the curve into intermediate and longer-duration fixed income ETFs to lock in yields for a longer period of time. One example of this can be seen in BondBloxx ETFs.
For instance, the BondBloxx Bloomberg Ten Year Target Duration US Treasury ETF has seen $49 million of inflows YTD. This is more than 50% of net inflows over all of last year. In contrast, the BondBloxx Bloomberg Six Month Target Duration US Treasury ETF only has $17 million of net inflows YTD, while it had $904 million of inflows last year.
BondBloxx has also seen similar flows from its 1 Year and 2 Year duration-focused Treasury ETFs. To appeal to fixed income investors seeking longer duration exposure, the firm recently launched 3 high-yield corporate bond ETFs with time frames of 1-5 years, 5-10 years, and more than 10 years.
Finsum: Flows into fixed income ETFs remain strong in 2024, but one definite change is that investors are favoring intermediate and longer-duration ETFs in anticipation of the Fed cutting rates.
Stocks were lower, while Treasuries caught a bid following the latest FOMC meeting which was deemed hawkish despite the Fed holding rates as expected. In essence, Chair Powell’s remarks during the press conference made it clear that the central bank is not willing to cut yet.
In response, markets were in a risk-off mood. Fed futures showed that the odds of a rate cut at the next meeting declined from 40% to 36%, while the odds of the first cut happening in May increased to 59% from 54%.
Overall, the policy statement and Powell’s press conference underscored that the Fed is moving in a more dovish direction, just not as fast as the market’s desired pace. The policy statement expressed that there is a better balance in terms of employment and inflation goals. However, before cutting rates, it wants to see even more progress on the inflation front. In essence, the resilient economy and labor market mean that the Fed has more latitude to continue its battle against inflation before pivoting to support the economy and risk re-igniting inflationary pressures.
Rather than hawkish or dovish, its current stance can be characterized as ‘data-dependent’. Some of the important releases, prior to the March FOMC meeting, will be the January and February employment data and consumer price indexes.
Finsum: The Fed held rates steady but came out slightly more hawkish than expected. This led to the odds of a rate cut in March slightly dropping, but the bigger takeaway is that the Fed sees inflation and employment risks as being balanced and remains data dependent.
With a strong recovery in fixed income over the past couple of months, fixed income fund managers are looking to generate inflows from the nearly $6 trillion that is sitting in money market funds. Some portions will certainly move into fixed income especially if interest rates start to move lower, and investors look to move further out on the curve to take advantage of still attractive yields.
Due to this, active fixed income funds delivered their biggest monthly returns in decades, leading to a surge of inflows. Recent economic data and chatter from FOMC officials have also been supportive of the asset class.
The challenge for managers is the explosion in active fixed income funds over the last few years, leading to price wars for market share and consolidation. Many are from the largest asset managers like Vanguard, State Street, and Blackrock, which have very low costs. Funds that aren’t able to sufficiently attract inflows over this period will only face more difficulties in the future in remaining viable.
According to Rich Kushel, the head of Blackrock’s portfolio management group, “We are in a winner-takes-a-lot moment. If you’re truly adding real alpha, there will always be a place for you in this industry. For the folks who haven’t, you might as well buy [the benchmark].”
Finsum: There is nearly $6 trillion on the sidelines. Some of this will move into fixed income especially if rates start dropping. There will be intense competition among active funds to be a recipient of these inflows.
In 2024, the major market narrative has certainly shifted from whether the Fed will cut or hike to when and how much the Fed will cut. According to Steve Laipply, BlackRock’s Global Co-Head of Bond ETFs, it’s a good time to lock in yields. Currently, investors can achieve yields of 4% in low-risk, diversified bond funds which is quite attractive relative to recent history.
During the previous cycle, investors would have to buy riskier high-yield bonds to achieve such income. Overall, he believes that investors have been overly risk averse during this tightening cycle, and most are underexposed to the asset class. Despite the recent rally, there are plenty of opportunities to capture generous yields with lower levels of risk. Further, fixed income would benefit if the economy weakened further, and inflation continues to lose steam.
While investors can get even higher yields in the front-end of the curve or with certificates of deposit, Laipply doesn’t see this as a prudent approach given underlying macroeconomic trends, and the Fed’s dovish tilt in the new year. He recommends that investors choose a diversified, broad bond fund like the iShares Core US Aggregate Bond ETF or an active fund like the Blackrock Flexible Income Fund.
Finsum: According to Steve Laipply, Blackrock’s Global Co-head of Bond ETFs, investors should lock in yields given the rising chance of a recession, slowing inflation, and a dovish Fed in 2024.
Currently, fixed income investors can lock in yields that are in-line with the average, historical return in equity markets. According to David Leduc, the CEO, Insight Investment North America, this is a major reason we are in a new ‘golden age’ for bonds.
Another reason to be bullish on the asset class is that most funds are deployed via passive strategies. This has increased liquidity and decreased transaction costs, while also leading to more inefficiencies which astute active managers can capitalize upon.
Leduc believes that fixed income benchmarks are inherently flawed given that indexes are weighted based on debt issuance. The end result is that passive fixed income investors are overexposed to the most indebted companies.
In contrast, active managers can achieve alpha through careful selection in terms of value, credit quality, and duration. While passive funds invest in a relatively small slice of the fixed income universe, active managers have much more latitude in terms of securities to better optimize portfolios in terms of risk and return. One constraint for active managers is that some strategies are successful but can’t necessarily be scaled. Many err by simply sticking to duration positioning which increases near-term volatility.
Finsum: It’s a golden age for fixed income with bonds offering equity-like returns. Here’s why investors should favor active strategies especially as the risk of a recession grows.
Aeon conducted a survey of pension funds, insurance asset managers, family offices, and wealth managers. Among the findings was that a majority plan to increase their allocation to active fixed income funds over the next 2 years. Currently, about 17% of respondents have less than 10% of their portfolios in active fixed income strategies, while 20% have between 50 and 75% of their portfolio in active fixed income. Overall, respondents are willing to trade liquidity for greater returns and diversification.
The survey also indicates that 13% of respondents plan to ‘dramatically’ increase exposure, while 81% plan to do so ‘slightly’. In terms of return expectations, 55% are looking for between 3 and 5%, while 36% are looking for between 5 and 7%.
In terms of alternatives, there was nearly unanimous consensus that the asset class would continue to grow as 74% see a slight increase over the next 2 years, while 16% see a dramatic increase.
Another area of agreement is that these allocators are looking for fund managers with a ‘broad mandate’ to invest in several credit markets. The respondents also shared the view that they would be increasing allocation to private credit with 24% looking to ‘dramatically’ increase, and 67% seeing a slight increase.
Finsum: Aeon conducted a survey of institutional investors. Among the findings was a consensus agreement that allocations to active fixed income strategies would materially increase over the next 2 years.
Entering 2023, the consensus was that fixed income would outperform. This turned out to be incorrect as the economy and inflation proved to be more resilient than expected. For the year, the Bloomberg US Aggregate Index returned 5.5% which is in-line with the average return although the bulk of gains came in the final months of the year.
As the calendar turns, the consensus is once again that the Fed is going to be embarking on rate cuts. Currently, the market expects 6 cuts before year-end which means there is room for downside in the event that the Fed doesn’t cut as aggressively. According to Bernstein, this may be premature as the firm sees many reasons for upward pressure on yields including inflation re-igniting, heavy amounts of Treasury debt issuance, and an acceleration of economic growth.
Bernstein recommends that investors eschew more expensive parts of fixed income like high-grade corporate debt. Many are unprepared for a scenario where spreads tighten or rates fall less than expected. Instead, it favors segments that would benefit from stronger growth like preferred securities and AAA collateralized loan obligations (CLOs). The firm also likes TIPS and the 2Y Treasury as these offer attractive yields and inflation protection.
Finsum: While most of Wall Street is bullish on fixed income in 2024, Bernstein is more cautious due to its expectations that rates will fall less than expected, while valuations are not as attractive.
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Stocks and bonds were both down following comments by Federal Reserve Governor Christopher Waller that rate cuts will be implemented slowly. Both are now in the red on a YTD basis. According to Waller, “When the time is right to begin lowering rates, I believe it can and should be lowered methodically and carefully.” As opposed to previous cycles, when cuts were implemented aggressively and quickly, Waller sees a slower, more gradual pace this time around.
His comments had a chilling effect, especially as financial markets had been in a buoyant mood, looking ahead to rate cuts later this year and the possibility of a ‘soft landing’. While Waller injected a dose of hawkishness, recent economic data has also been on the weak side, adding to recession fears. Needless to say, such developments reduce the odds of a ‘soft landing’ scenario.
Currently, Fed futures markets indicate a 60% chance of a cut at the March FOMC meeting. Going into that meeting, inflation and labor market data will be major factors in this decision and market-moving events. Q4 earnings season is also starting, and it will be worth watching whether the improvement in Q3 will continue. The current consensus is for S&P 500 Q4 earnings to increase by 1.6% compared to last year.
Finsum: Stocks and bonds weakened following hawkish comments from Fed Governor Waller. Waller sees a slower pace of rate cuts during this cycle than previous ones.
2023 saw many twists and turns in financial markets. Yet, one enduring trend was the growth of active and fixed income ETFs as measured by inflows and new ETF launches. Andres Rincon, the Head of ETF Sales and Strategy at TD Securities, shares why this was the case and what’s next for 2024.
A major factor is that mutual funds had net outflows, while ETFs had nearly an equivalent amount of inflows. This is an indication of a secular shift as investors and institutions increasingly favor ETFs due to more liquidity and transparency. In response, many asset managers are now converting fixed income mutual funds into active ETFs or offer dual versions.
Fixed income ETFs also benefited from yields being at their highest level in decades in addition to an uncertain economic outlook. Despite the rally in fixed income in the last couple of months of 2023, Rincon notes that investors had been positioning themselves for a downturn in the economy and pivot in Fed policy starting early in the year.
Flows into active fixed income ETFs have also been strong, given that fixed income is more complex than equities. This is despite these ETFs typically having higher fees. Yet, active managers are able to take advantage of inefficiencies that are unavailable to passive funds. And, active is a particularly good fit for the current moment when there is indecision about the timing and extent of the Fed’s next move.
Finsum: TD’s Andres Rincon discusses what drove the surge of inflows into fixed income and active ETFs last year. And, why these trends should continue in 2024.
PIMCO sees a changed environment in 2024 as the Fed will pivot to rate cuts. However, it sees the impact of prior rate hikes still impacting economies and leading to stagnation or a mild contraction.
Financial markets will be focusing on the timing and pace of rate cuts. Based on history, central banks don’t ease in anticipation of economic weakness. Instead, they tend to cut only after recessionary conditions materialize and tend to cut more than expected by the market.
PIMCO agrees with Chair Powell that inflation and growth risks are now more ‘symmetrical’. However, it believes the market is underpricing recession risk especially given that some assets are already priced for a soft landing given the strong rally in many assets over the past few months.
It also believes that fixed income is particularly appropriate for this environment given that yields are still close to multi-decade highs. It also offers protection and upside in the event of economic conditions deteriorating. Within the asset class, it favors mortgage-backed securities and believes investors should stick to medium-duration bonds as yields are attractive while interest rate risk is reduced. On a longer-term basis, PIMCO sees neutral policy rates to reach similar levels to before the pandemic which is also supportive of the category.
Finsum: PIMCO sees financial conditions easing in 2024 as the Fed cuts rates, but economic conditions will deteriorate given the delayed impact of tight monetary policy.
There’s a major drawback to today’s hyper-connected world where investors are constantly receiving financial advice that is mostly short-term and doesn’t necessarily have the investors’ best interests in mind. Contrast that approach to a long-term, fundamental based approach that is based on timeless principles rather than impulsive thinking.
Recently, there has been a narrative that individuals should be buying individual bonds. Adam Abbas, a portfolio manager at Oakmark Funds, pushed back against this notion and made the case for why most investors are better off with mutual funds and ETFs.
He acknowledges that bonds look very appealing given where rates are relative to historic levels and that default rates for high-quality securities are likely to remain low. However, the risk climbs when investors start ‘reaching for yield’ which tends to happen with individual investors. Therefore, some sort of comprehensive credit analysis is required from a bottom-up perspective.
Further, most individual investors will not be able to sufficiently diversify their portfolios. This means that their portfolios would be damaged by a corporate bond default. In addition to understanding companies, investors also need to have a grasp on the macro picture as factors like inflation or rate policy can also impact returns.
Given these difficulties, most investors are better off choosing an astute active manager to invest in bonds as they will conduct proper due diligence and ensure that portfolios are sufficiently diversified.
Finsum: There’s a trend of individual investors buying individual bonds. Oakmark’s Adam Abbas pushes back against this and makes the case for why most investors are better off with a mutual fund or ETF.