Investors must “stay vigilant to risks” when it comes to selecting fixed income funds, according to the research team at Square Mile, despite the fact rate cuts in the US spell online good news for bond investors.
In a research note published at the end of last month, following the US Federal Reserve’s decision to cut interest rates by 50 basis points, the team said this provides “a pivotal moment for markets as a whole”.
When it comes to fixed income in particular, it said the cut could “finally be a turning point” for bond investors who have dealt with “challenging, volatile market conditions for a number of years”.
There is no denying that the last two years have been tough for fixed income investors.
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“The inflation experienced in 2022, coupled with the aggressive monetary policy that followed from central banks [including the Fed] created an incredibly difficult backdrop,” the team wrote. “Furthermore, volatility has continued to characterise the markets too, and has been exacerbated by investors expecting a rate cut far sooner than September 2024.
“In fact, interest rates remaining elevated, following the Fed’s aggressive rate-hiking cycle, has been one of the biggest issues for investors. Arguably, though, rates had to remain higher as inflation proved to be stubborn and resisted tightening measures made by the Fed.”
Therefore, the Square Mile’s research team said the Fed remained hawkish, leading to higher yields and higher coupons on bonds, while bond prices remained suppressed.
“Now, the pendulum seems to have swung for policymakers,” it said. “The risk for the Fed is no longer inflation, but a slowing economy. The rate cut could, therefore, be the key to unlocking returns many bondholders have been waiting for as when interest rates fall, bond yields typically decline as well, pushing bond prices higher.
“For those holding existing bonds, this is particularly beneficial as the value of their bonds rise in response to lower yields in the broader market.”
What’s more, the fact the US central bank is moving in line with broader market expectations gives “a clearer insight into the future”, the team said. While monetary policy decisions can be surprising and against consensus, Square Mile believe investors can now count on further interest rate cuts, which will continue to support bond prices.
Which bond funds are attractive?
Square Mile said there are “several” types of bonds funds that now look attractive. For instance, the team currently favours investment grade credit over government bonds, due to a favourable economic backdrop for company earnings.
Overall though, it prefers strategic bond funds, which are able to invest across a range of fixed income assets and rebalance portfolios depending on the top-down and bottom-up opportunity set.
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“For many, the news of a rate cut should be promising especially for bondholders, given the rollercoaster ride of the last two years for fixed-income investors,” Square Mile concluded. “Bonds won’t just be used to mitigate risk in equities; they could also generate returns in themselves.
“That being said… we still believe it’s vital to stay vigilant to risks too. After all, the Fed has cut its rate by more than many assumed, in response to weak economic data. Being flexible and taking a diversified approach will be essential to navigating any further tricky periods, as well as adjusting interest rate risk as required by market conditions.”
