The Clock is Ticking: How Investors Can Lock In Higher Yields As Rates Dip
As the Federal Reserve contemplates a potential rate cut in September, investors who have been enjoying high yields on cash are facing a crucial decision. With rates likely to trend downward, those 5% yields on cash are at risk of disappearing. This presents a prime opportunity for investors to shift some of their cash holdings into longer-term bonds, aiming to lock in today’s attractive yields and benefit from price appreciation as interest rates decline.
Key Takeaways:
- The Fed’s potential rate cut could see yields on short-term instruments like money market funds and high-yield savings accounts drop significantly.
- Investing in longer-term bonds can help lock in higher yields currently available and capitalize on price appreciation as rates fall.
- Core bond funds, with their diversified holdings of treasuries, mortgage-backed securities, and corporate bonds, offer stable returns and intermediate duration.
- Municipal bonds provide tax-free income, especially valuable for high-income earners, and can enhance duration and yield.
- A "barbell strategy" using short-maturity and high-yield municipal bond ETFs can offer a balanced approach to duration and yield.
Navigating the Shifting Landscape of Fixed Income
The possibility of falling rates is pushing investors to re-evaluate their fixed income strategies. Holding onto cash, while appealing for its liquidity, could lead to eroding purchasing power as yields dwindle. Enter the realm of duration – a measure of a bond’s price sensitivity to interest rate changes. Longer-maturity bonds generally exhibit higher duration, making them more responsive to rate shifts.
"It favors longer-term strategies: You can have some duration and still get pretty strong yield, so the income component is pretty attractive relative to where it’s been for the past two decades," states Paul Olmsted, Senior Manager Research Analyst, Fixed Income, at Morningstar. This highlights the compelling opportunity to secure strong yields while benefiting from potential price appreciation as rates decline.
Core Bond Funds: A Robust Foundation for Stability
For investors seeking a conservative entry point into fixed income, core bond funds present a reliable option. Their diverse portfolio of investment-grade corporate bonds, mortgage-backed securities, and asset-backed securities provides relative stability and diversification. These funds tend to have a intermediate duration of roughly four to six years, offering a balance between yield and price sensitivity.
"When you have a market where you have mixed signals, diversification is your friend," emphasizes Olmsted, underscoring the advantages of core bond funds in periods of market uncertainty.
Two prominent core bond funds include:
- Vanguard’s Core Bond Fund (VCORX): Boasting a 30-day SEC yield of 4.47% and an expense ratio of 0.20%, this fund carries a duration of 5.9 years.
- Fidelity Intermediate Bond Fund (FTHRX): With a 30-day SEC yield of 4.32% and an expense ratio of 0.45%, this fund offers a shorter duration of approximately 3.8 years.
Core-Plus Bond Funds: A Step Up in Yield and Risk
Seeking higher yields? Core-plus bond funds offer a potentially attractive option. These funds typically incorporate a larger allocation towards higher-yielding, albeit riskier, segments of the bond market, including high-yield bonds. This "plus" element can boost returns by as much as 20 basis points. However, it comes with increased exposure to the potential downsides of a weakening economic environment.
Vanguard’s Core-Plus Bond Fund (VCPIX) serves as a prime example. With a 30-day SEC yield of 4.66% and an expense ratio of 0.3%, this fund holds approximately 8.9% of its assets in BB-rated bonds and 2.6% in B-rated bonds, classifying them as "speculative grade" by rating agencies.
Municipal Bonds: Tax-Free Income and Enhanced Duration
For investors in high income tax brackets, municipal bonds present a compelling opportunity to enhance duration and unlock tax-free income. These bonds generate income that is exempt from federal taxes, and in some cases, state taxes depending on the issuer. Though their yields might not match those of corporate bonds, their unique tax advantages make them highly appealing for those seeking to maximize after-tax returns.
"Clients want to hang out in the front end of the yield curve, and it feels like the Fed cutting is what will create the impetus to go ahead and move," notes Sean Carney, Chief Investment Officer of Municipal Bond Funds and Head of Municipal Strategy at BlackRock. This points to the potential shift in investor behavior as rates decline, favoring longer-term strategies.
"Munis continue to do the same things you want them to do: They are low volatility, give off attractive yield, defaults continue to be low, and upgrades are outpacing downgrades," adds Carney, highlighting the continued attractiveness of municipal bonds.
A Barbell Strategy: Balancing Duration and Yield with ETFs
Combining short-maturity municipal bond ETFs with high-yield municipal bond ETFs can create a "barbell strategy" that effectively balances duration and yield. This strategy aims to capitalize on the shorter-term yields while adding exposure to higher-yielding opportunities.
BlackRock’s Short Maturity Municipal Bond ETF (MEAR) and High Yield Muni Income Bond ETF (HYMU) offer a compelling combination for this purpose.
"We think of that as a way to be active in the market and barbelled from a yield curve perspective and credit perspective," affirms Carney, highlighting the potential advantages of this balanced approach.
The Bottom Line: A Time for Strategic Action
The changing landscape of interest rates presents a crucial opportunity for investors to re-evaluate their strategies. Locking in higher yields on longer-term bonds while securing tax advantages through municipal bonds can bolster investment portfolios as rates potentially decline. By exploring core bond funds, core-plus bond funds, and barbell strategies, investors can navigate this dynamic environment and potentially position themselves for success in the coming months.
