The Cost of Waiting for Goldilocks

Janet Rilling: These allocations continue to offer us attractive income while providing good diversification when we see the relative value of the credit sectors improve.

Danny Sarnowski: That’s Janet Rilling, head of the Plus Fixed Income team here at Allspring Global Investments. And I’m Danny Sarnowski, portfolio specialist for the Allspring Plus Fixed Income team, and you’re listening to On the Trading Desk®. Today, we’re discussing the bond markets and the opportunity costs that investors may incur as they look for a Goldilocks moment to position their fixed income portfolios. Thanks for being here, Janet.

Janet: Hi, Danny. It’s great to be here.

Danny: Fixed income investors have had to navigate a pretty radical set of changes over the last year, haven’t they?

Janet: They certainly have. Investors went from living through a period of near-zero interest rates to watching yields jump to their highest levels in 15 years. That change was caused by the highest inflation in a generation that led the U.S. Federal Reserve to raise rates higher and faster than they have at any point since the 1970s.

Danny: Yeah.

Janet: Yields across the curve have risen in sympathy, and the curve has inverted.

Danny: That’s a tough change for investors since rising bond yields result in lower bond prices.

Janet: They do, and 2022 was the worst year of total returns on record for most fixed income indexes. Those sharply negative returns in the inversion in the yield curve and the very high level of income on the front end of the curve has led many investors to shorten their duration. And as a reminder, duration is a sensitivity to changes in interest rates. With that shortening of duration, investors have been moving allocations to the very front end of the curve focusing on cash money market funds, or very short-maturity securities. In fact, money market mutual funds have recently reached a new all-time peak in assets with more than 5.6 trillion as of the end of March.

Danny: While the current landscape is a positive for cash and ultra-short investors who have had to accept just-barely-above-zero yields for a really long time, for those investors who need daily liquidity and want some income, this environment is welcome and very attractive.

Janet: Yeah.

Danny: For longer-term investors, however, or those who would typically be invested further out the curve, that concentration on the front end, I think, can lead investors to miss out on total return opportunities. You know, we’ve found that in previous rate hike cycles, investors tend to wait for this Goldilocks moment to add duration back to their portfolios. And I’m certainly hearing that, in a lot of the dialogues I’m having with clients and investors, people seem to know that they want to make a change, or they should, but they’re really just sort of frozen as they consider how and when to make that jump.

Janet: Yeah, those higher yields on the front end of the curve without the volatility of more duration-sensitive exposures can be alluring. But it should be noted that high yields are not unique to just the front end. Yields are actually at or near 10-year highs across the entire curve. And when we look globally beyond the U.S., yields are also higher than they were a year ago. We believe that this last quarter likely marked an inflection point in the markets. We saw evidence through the regional banking crisis that that cumulative weight of all of these Fed rate hikes has begun to weigh on the economy and we expect that we will see further evidence of stress in the system and that economic growth may be more challenged going forward. We also saw the inflation metrics, including the Fed’s preferred gauge of inflation—that’s the core PCE—modestly decline. The combination of gradual improvement in inflation and growing signs of the lagged effect of monetary policy led us to expect that the Fed is nearing the end of their hiking cycle.

Danny: Well, so the Fed might be nearing the end of the cycle. And that means rates may sort of on the front of the curve may start to tap out. And this is that point, I think where the concentration on the front end of the curve can lead investors to miss out on opportunities to incur opportunity costs. In the past, we’ve seen investors sort of huddle on the front end of the curve waiting for the Fed to stop raising rates with this intention that they’ll perfectly market time back into longer-duration exposures before rates get cut. Again, I think the idea is to sort of just step to the sidelines, wait out the Fed, take advantage of the higher income that’s available in cash and liquidity instruments, and then try and redeploy before rates get cut.

Janet: I think many of us have experienced the fact that market timing is always difficult and the precise moment to add duration or make a major allocation shift in a portfolio can be a challenge to anticipate. The Fed doesn’t proactively cut rates, but rather, their hands are typically forced due to an unanticipated change in the economy or some sort of shock, like we saw during 9/11 or during COVID.

Danny: And more than that, though, I think we’ve found over the last four periods of Fed rate tightening in the last 30 years that investors who had some duration exposure achieved higher total returns than those investors huddled down on the front end of the curve, even in this period, when the Fed strips stopped raising rates and before they cut again. The current rate hike episode is thus far playing out in a similar fashion. We saw intermediate rates peak late last year in October and so those opportunity costs have sort of already started to pile up.

Janet: Yeah.

Danny: Since peaking last October, the 10-year Treasury returned just over 8% in total return through the end of the first quarter of this year, while three-to-six-month T-bills returned just under 2%, despite them having a higher yield than the 10-year Treasury. And, so, for a lot of investors, I think the idea of just pushing from sort of the relative safety on the front end out to longer duration is just very tough. There’s just a lot of inertia built in there. But I know we’ve spoken and there are some strategies that investors can leverage to try and break through that inertia and stop waiting around for Goldilocks.

Janet: One strategy is dollar cost averaging into longer-duration allocations. The way to think about it is an exposure doesn’t have to be all or nothing. An investor could move a portion of their fixed income allocation back over to long-duration exposures to lessen the need to try to perfectly time the move. Another strategy is to layer allocations across the curve. So, investors can do what we have been calling ride the curve, meaning diversify their exposures. To that end, they could keep a portion in cash or at the very front end and then consider deploying an allocation to a short-term strategy, adding some to a more intermediate strategy, and then a final layer in some longer exposures.

Danny: Yeah.

Janet: And then, when the yield curve normalizes, even before the Fed begins to lower rates, that diversified set of exposures would stand to benefit.

Danny: Yeah, I think those are helpful ideas. Beyond this duration move we’ve been talking about, are there other thoughts that you’d want to share with our listeners?

Janet: One last thought to share is that while we are comfortable owning duration at this point in the cycle, we do think investors should be a bit more cautious about credit exposures. If there is more pain to be felt as a result of the Fed’s rate hiking efforts, we think that credit investors should be getting paid more for risk than we see currently in the marketplace. So, adding or layering in duration could be helpful, but staying higher up in quality, we think that is an important consideration at this point. To do that, we’ve found opportunities to deploy capital in a wide array of high-quality securitized sectors. And also, we’ve been taking advantage of the higher FX-hedged yields offered in global government bonds. These allocations continue to offer us attractive income while providing good diversification. And they provide a source of liquidity that we’ll be able to deploy when we see the relative value of the credit sectors improve.

Danny: Great. Thanks, Janet. I think that is an important consideration and I’m glad you raised that with clients. Thanks for being with us today and for sharing your insights.

Janet: Thank you, Danny. It was a pleasure.

Danny: And thank you for listening to On the Trading Desk®.

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