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 ending, and what are the implications for the short end of the yield curve?
We believe the Federal Reserve (Fed) is approaching a peak policy rate on its path toward its 2% goal. The Fed Summary of Economic Projections from March forecast the fed funds rate will reach 5.1% by year-end 2023, though we expect the Fed to cut rates earlier than that, more in line with market expectations. Our forecast is for a 50/50 chance that the Fed hikes one more time at 0.25% or the Fed does not hike at its May meeting before pausing until later in the year.
The implication for investors in short-dated bonds is that the short end of the curve could now offer attractive yield and income, especially in maturities dated 1-year and in. That was very much not the case when this hiking cycle began in early 2022.
Ultrashort bond funds can help investors combat the effects of market volatility by lessening exposure to interest rate risk and spread risk.
What are the benefits of ultrashort funds in the current market?
Ultrashort bond funds (those 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, ultrashort funds typically offer a higher yield than cash. That combination of risk mitigation and income is especially important in today’s late-cycle environment. Importantly, given the inversion of the yield curve, front-end yields are relatively competitive with those of many longer-dated strategies.
Do you see short Treasuries as attractive given your ultrashort mandate?
Short Treasuries have become more attractive as the hiking cycle has progressed; however, we continue to prefer 1-year high-quality credit. Treasury bills with the highest yields (currently at the 6-month point in the curve) have maturities that fall squarely in the debt ceiling X-date window. This is something we prefer to avoid for the time being. We have added a small position in 18-month Treasuries as we begin to see value in adding high quality duration to the portfolio. We have also added a long position in U.S. Treasury futures at the 2-year point in the curve to support a longer-duration view.
We continue to find the most value in one-year money market instruments and will selectively add longer-maturity credit if spreads and yields warrant.
How is the portfolio positioned today?
We see value in adding longer positions to the portfolio as we approach Fed peak policy. We continue to find the most value in one-year money market instruments and will selectively add longer-maturity credit if spreads and yields warrant. We remain constructive fundamentally on Financials even given the recent volatility. Financials provided better value than Industrials prior to the sell-off for technical reasons and now provide even more value. However, given the recent volatility surrounding Banking, we are being extra cautious on the sector as a whole. We are paying special attention to smaller banks and have taken steps to reduce smaller bank positions.
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 ultrashort fixed income?
There are passive strategies in the ultrashort 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 ultrashort strategy.
What is your outlook for the strategy’s yield throughout 2023?
Historically, movements in cash reserve yields have been highly correlated with movement in the fed funds effective rate (the volume-weighted median of overnight rates charged by banks for lending to other banks across the U.S.). Given the credit holdings of cash reserve funds, they typically provide meaningfully higher yields than the fed funds effective rate. With the inversion of the yield curve and our preference to begin adding duration, that yield spread has narrowed. As we approach peak policy from the Fed and add duration, we expect the yield to begin to trend modestly down given the inverted shape of the yield curve.
Keep in mind that the tilt toward duration may allow the strategy to lock in higher yield for longer (vs. money market funds or deposits) if the Fed cuts rates. Duration would also benefit from the downward rate movement that would likely accompany rate cuts.