As interest rates approach their peak, bond investors are being urged to explore longer maturities and move away from short-term cash, according to experts.
This week, all eyes are on the Federal Open Market Committee (FOMC) to see if they will raise the benchmark rate by 0.25 percentage points. Federal Reserve Chairman Jerome Powell’s remarks on inflation and the labor market will provide clues on the possibility of further rate increases before year-end.
The majority of investors predict that this week’s rate hike will be the last in the current cycle. Nonetheless, bond investors need to change their playbook, say experts.
Jonathan Rocafort, managing director and head of fixed income at Parametric Portfolio Associates, sees this as an opportunity to shift away from cash, extend duration, and secure yields.
While cash has been profitable in the past year, the situation may change as rates start to decline. Short-term investors face reinvestment risk, meaning they may have to reinvest their money at lower rates when their investments mature.
To mitigate this risk, Marina Gross, co-head of Natixis Investment Managers Solutions, recommends that investors diversify their exposures across the yield curve.
Investing Strategy Amid an Inverted Yield Curve
The Power of a Gradual Approach
According to financial expert Gross, adopting a gradual approach is the best defense when faced with an inverted yield curve. Instead of making bold moves, it is advisable to start by bulleting out the curve.
The Counterintuitive Move
Despite the current inversion of the Treasury yield curve, it may seem counterintuitive to extend maturities. This is because investors are not rewarded with a higher yield for investing in a 10-year bond compared to a two-year note.
However, this cautious move has its advantages. Alongside protecting against reinvestment risk, it also helps shield investors in the event of an impending recession. Gross points out that when investors sense a recession approaching, they tend to flock towards the safety of bonds, resulting in price increases and lower yields. This rally proves beneficial for those holding longer-duration bonds, as they are most sensitive to changes in interest rates.
A Possible Fed Pause
Currently, all indications suggest that the Federal Reserve will take a pause and maintain interest rates after a July hike. They aim to closely monitor data to determine if inflation has reached their desired target. Based on an analysis by Parametric Portfolio Associates, historical data from previous tightening cycles revealed that intermediate and longer-term bonds tended to outperform cash 12 months after the last rate hike.
Rajeev Sharma, Managing Director of Fixed Income for Key Private Bank, remarks that the pause scenario is highly favorable for fixed income investments.
