Nearly two and a half years after the Federal Reserve kicked off a massive increase in interest rates, the bond market is heading in a new direction.
It is widely believed that the central bank will kick off a series of interest rate cuts in September. That should be good news for bond investors. The big unknowns are how far bond yields will come down, and at what pace. Also unknown is which corners of the bond market will outperform and which will lag. That has fund managers charting different potential approaches.
One question is the degree to which long-term bond yields will come down within an economy that has remained stronger than many observers expected. That could limit the drop in long-term yields. At the same time, if a slowdown in growth turns into a recession, long-term yields could rally and riskier bonds—which are more expensive than safer ones—could suffer.
"Currently, the Fed has said explicitly that any moves they're going to make are data-driven. Typically you have more of a narrative ... the beautiful thing about this environment is you can fit any narrative to it," says Greg Peters, co-chief fixed income investment officer at PGIM and one of the managers of the $47.9 billion PGIM Total Return Bond PTRQX.
Fed Rate Cuts on the Way
It's seen as a near certainty that the Fed will announce a rate cut at its policy-setting meeting on Sept. 18, lowering the key federal-funds rate for the first time since surging inflation led to its most aggressive rate increases in history.
The CME FedWatch tool shows that futures markets predict a 64% chance of a quarter-point cut, while odds of a more aggressive half-point cut are seen at 36%. Just a month ago, the markets expected only a 4% chance of a 0.5% cut. But in the wake of a weaker-than-expected jobs report which showed unemployment hit 4.3% in July (up from 3.7% at the start of the year), recession fears flared and expectations grew for bigger rate cuts.
Richard Figuly, a portfolio manager for the $47.4 billion JPMorgan Core Bond Fund JCBUX, believes a rate cut of at least 0.25% is "baked in" for September. He thinks it's about a 50/50 chance whether the Fed cuts by a quarter-point or half-point.
There's less certainty about where rates will be by the end of the year. The futures markets put a 28% change on three 0.25% cuts, a 45% chance of four, a 23% chance of five, and a 4% chance of six. "We expect the Fed will cut 25 basis points at each of the meetings for the rest of the year," says Matt Brill, a portfolio manager on the $2.9 billion Invesco Core Bond Fund OPBIX.
Will the United States Avoid a Recession?
The key question for the bond market's outlook is the economy's trajectory. For now, data suggest economic growth has slowed. "It's clearly a trend toward a weaker or softer labor market. But is it rolling over and falling off a cliff? No, that's not what we're seeing yet. That could happen, but we're not quite there yet," says Figuly.
Brill pegs the odds of a recession at 25% or less. He says the Fed is alert to recession risk and will take prompt action, while corporate balance sheets are in good shape. "The Fed right now is kind of like lane bumpers in bowling. If anything goes too off-track, they'll knock it right back," he says.
Peters offers a similar outlook: "we have [the chance of a] recession at 20%, which is still elevated, but by and large a pretty decent backdrop."
How Much Will Long-Term Yields Fall?
The next question is how the intersection of economic growth and Fed policy will play out in the market. A key debate is whether to position portfolios to be more sensitive to changes in yield—a metric known as duration.
"We're already a little overweight duration," says Figuly, meaning his fund is slightly more sensitive than its benchmark, the Bloomberg US Aggregate Index. JPMorgan Core Bond Fund is also positioned in such a way to benefit more as bond prices rise than they would decline should yields rise.
"Positive convexity acts as a duration management tool," says Figuly, explaining that as rates fall, the fund will become more overweight duration versus its benchmark. While it's slightly overweight duration, the JPM fund's main play with rates is a strategy known in Wall Street jargon as a yield curve steepener. The fund owns 2- and 5-year notes but is betting that prices on the 30-year Treasury bond will fall. This strategy is duration-neutral, meaning the net effect of the trade doesn't extend the fund's duration. Figuly also says that if they see indications a recession is coming, the fund will want to add more duration overall.
While Peters says the PGIM fund is slightly underweight duration, they manage this differently than the other two funds. "We separate all the risks, so we think about duration as very different than spread risk or currency risk." He points to the fund's investment in AAA-rated collateralized loan obligations, which are floating-rate, meaning their interest payouts rise and fall with rates. This would typically mean they're not a good investment for a falling-rate environment, but by using futures contracts to eliminate the duration risk, they can focus on the CLO's credit spreads (how much more yield it offers above a baseline), which they think are attractive.
Differing Views on Credit Risk
The other key variable is the degree to which funds are betting on non-US government bonds at risk of default. This generally involves investment-grade corporate bonds, high-yield bonds, or other securities, such as mortgage-backed bonds.
The question is whether the yields on credit offer enough cushion, or spread, above safe bonds like US Treasurys. Narrow spreads mean they offer comparably little extra yield compared with historical averages. Since bond prices move in the opposite direction of yields, this means there's less room for riskier assets to rise in price.
All three managers agreed that bond spreads were fairly tight, meaning the extra yield for taking riskier assets was low compared with historical averages, resulting in lower rewards for taking risks.
Peters lands in the cautious camp: "we have a risk threshold for the fund, and we can go to 120% of that threshold. We're normally around 80%, and we're at about 40%-45% right now. The kind of upside just isn't that attractive. I'm not calling for the world to end by any stretch; I just feel like, as an investor, I'm not being rewarded for taking that risk."
Brill lands in the middle ground, saying his fund is "more of a six out of 10 right now" in terms of how aggressively it's investing. "We're overweight credit risk, and we think it will serve as a nice hedge to be a little bit overweight duration," he says. "There's a limited upside, but we also feel there's a limited downside," he adds.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies
