When Collin Martin, a Charles Schwab director and fixed-income strategist, had to send in the title for a presentation at IMPACT 2024, coming up with “Fixed Income Strategies in a Falling Interest Rate Environment” was easy enough.
Too bad it was 100% wrong.
“We have to submit our titles months in advance,” he said last week at the conference in San Francisco. “So we have a little bit of an asterisk here, and you are now in a new session titled ‘Fixed Income Strategies in a Flat or Potentially Rising Rate Environment.’ So thank you all for coming.”
The switch was the direct result of some large economic, market and political shifts that have turned expectations for fixed-income investing around in the last few weeks, he said.
“What happened starting in the middle of September probably caught a lot of your clients off guard when we saw 10-year Treasury yields, and pretty much all Treasury yields, rise pretty sharply right as the Federal Reserve began cutting interest rates,” Martin said. “We should take a look back and talk about what happened, what it means for your clients' portfolios and where there might be some areas of opportunity.”
In short, the 10-year Treasury yield had been steadily declining over the last year in keeping with expectations for lowered economic growth and slowed inflation. But at the same time the Fed came in with a 50-basis-point cut, there was a rising probability of a Donald Trump victory in the presidential election, more evidence of a strong economy and stickier inflation, he said.
Martin said that earlier this year, the expectation was that the Fed would cut rates gradually to 3% or less. Today, the expectation for the terminal rate has risen to 3.75% to 4%, he said, and that would push Treasury yields higher.
With that as a backdrop, Martin said he has two concrete recommendations for advisors and the fixed-income portfolios they might oversee.
First, he suggested backing off duration. While over the past few years he said he’s encouraged investors to extend duration to “lock in higher yields with certainty,” that advice has flipped around.
“Now we're suggesting a benchmark or even below-benchmark average duration, mainly due to so many of the risks that are out there, where we have inflation proving sticky right now, and we have a lot of proposed policies that, if enacted, could be inflationary over time,” he said, adding that benchmark or below-benchmark average duration would be roughly six or seven years.
Second, from a core bond-holding point of view, he said TIPS are a good option, as “real yields are really high, and I think that's one area of focus that often gets overlooked.”
“If inflation is a concern of yours or your clients, it's certainly something to consider,” he said.
Right now, the fed funds futures market is still pricing in a cut in December, but there is also a potential for a pause in cuts, depending on the data in some upcoming reports, he said.
Fixed-income investments fitting well with mid-length duration can run the gamut from riskier investments like high-yield corporate and emerging markets to high-rated investments such as corporate bonds, mortgage-backed securities, Treasurys and agency bonds.
“You also have to figure out what makes sense for your clients. What’s their time horizon?” Martin said. “If they’re looking for income and have a long-term time horizon, you can get 4%, 5%, 6% yields without taking much risk. I think that's really important. It's a good way that you can add bonds, maybe de-risk elsewhere, and still help them reach their goals.”
This is where TIPS could come in, he said, as they can make a lot of sense when the outlook is that inflation will stay sticky for a while.
Among taxable corporate bonds, Martin said the fundamentals are very strong right now, but valuations are also very rich.
“Our main theme this year, and heading into 2025, is go up in quality,” he said, adding that for him that means investment-grade corporate bonds, where the yields they offer relative to the risks they provide are in balance.
“Even though we're a little bit cautious about extending duration right now, and we have our benchmark or below-benchmark average duration guidance, if you want to consider some intermediate-term corporates, I think it's a nice story to tell relative to Treasurys,” he said.
Another area, investment-grade floating-rate notes, tends to be dominated by banks and financial institutions, but Martin said the inverted yield curve is pushing floating-rate notes above 5% because their coupon rates are based off of the secured overnight financing rate, which is highly correlated to the fed funds rate.
“And if we look at this now, comparing a 5.3% average yield for floaters versus just under 5% for intermediate-term corporate bonds, if we assume a shallower path of rate cuts, maybe that average yield on the floater index gets to the 4.5% level,” said. “That's still pretty attractive. And you'd be protected should inflation really pick up and should the Fed stop cutting earlier and then have to reverse at some point down the road. That's a key benefit of floaters.”
Other popular investments, such as high-yield bonds, municipal bonds and preferred securities, leave him a little cautious, he said. With high-yield bonds, he said the spreads are so low that it would be hard to outperform other investments. It’s the same with munis and preferred securities, though these can have tax advantages that could help a client’s overall bond picture.