PM Corner: In conversation with James McNerny
Portfolio Manager James McNerny discusses the Fed hiking cycle and identifies opportunities on the short end of the curve
How do you see the Fed hiking cycle unfolding, and what are the implications for the short end of the yield curve?
We still believe that the Federal Reserve (Fed) has further to go to bring inflation near to its 2% goal. The Fed Summary of Economic Projections forecasts that the fed funds rate will reach 3.4% by the end of 2022 and 3.8% by the end of 2023. We see a similar trajectory.
The implications for investors in short-dated bonds are continued headwinds in the form of rising rates, though much of the anticipated forthcoming hikes are reflected in current market yields. However, the good news is, the short end of the curve now offers yield and income. That was very much not the case when this hiking cycle began in early 2022.
What are the benefits of ultra-short funds in the current market?
Ultra-short bond funds (with portfolio duration under one year) can help investors combat the effects of market volatility by lessening exposure to interest rate risk and spread risk. At the same time, ultra-short funds typically offer a higher yield than cash. That combination of risk mitigation and income is especially important in today’s late-cycle environment of rising rates and widening credit spreads.
The 2-year/10-year U.S. Treasury yield curve is currently inverted. What are your thoughts about the inverted yield curve?
Historically, an inverted yield curve has signaled a recessionary environment. We (as well as the Fed) pay closer attention to the fed funds/10-year yield curve. This slope has yet to invert, although we expect it will be near the point of inversion with the next rate hike expected in September.
The inverted yield curve presents opportunity on the short end of the yield curve. In particular, it offers the opportunity for attractive levels of yield, in some cases yields that are higher than longer-tenured instruments.
How is the portfolio positioned today?
In general, we are taking a cautious approach. There is still a lot of uncertainty about the path of inflation and the Fed’s reaction function (how it will respond to inflation and other economic data). Within the short end of the curve, we are currently biased to investing short in both rate duration and spread duration. Given the flatness of the curve, we don’t have to sacrifice much yield to come down the curve to lessen interest rate risk and credit risk.
What role does a cash reserves strategy play in portfolios? Is it a cash alternative?
On the risk/return spectrum, the cash reserves category is the first step out from a liquidity strategy that may involve cash, money market funds or bank deposits. It is not a cash alternative. The minimum recommended holding period for a typical cash reserve fund is 6–12 months. We are currently recommending the longer end of that holding period given the persistent volatility and uncertainty in markets.
Cash reserves can be thought of as a “core complement” within a fixed income portfolio, given the fact that the strategy:
Offers relatively lower duration, in the range of 3 months to 1 year
May help hedge the downside risk and volatility of a portfolio overall
Tends to have low correlation to traditional fixed income
How do you think about active vs. passive approaches in ultra-short fixed income?
There are passive strategies in the ultra-short space that consist mainly of Treasury or floating-rate credit funds. But we find that duration management, sector rotation and an active security selection, especially in the credit sector, is the most effective approach for delivering strong absolute and risk-adjusted returns in an ultra-short strategy.
What is your outlook for the strategy’s yield through the end of the year and into 2023?
Historically, movements in cash reserve yields have been highly correlated with movement in the fed funds effective rate (the weighted average of all rates charged by the banks for lending to other banks across the U.S.). However, given cash reserves funds’ credit holdings, they typically provide meaningfully higher yields than the fed funds effective rate. We expect this trend to continue. With the fed funds effective likely headed over 3% this year, we anticipate the strategy to yield well over 3% this year, too.