Moving beyond cash

Key takeaways

• Non-cash fixed income yields are more closely tied to intermediate-term rates, which tend to be more stable as the yield curve reshapes.
• Non-cash fixed income sectors may experience price appreciation as rates decline because their duration is greater than zero.
• We see attractive opportunities in the preferred securities market and in BB rated high yield and senior loans.

With the highest starting yields in 15 years, many fixed income sectors already produce more income than cash. And these sectors offer the opportunity for price appreciation once the U.S. Federal Reserve starts cutting rates, while the yield on cash will simply decline. We advocate a multisector approach that takes selective risk in credit sectors. Active management remains critical, as credit spreads are likely to widen in the coming months.

Yields present the best starting point in more than 15 years

Higher U.S. Treasury rates and wider credit spreads have significantly enhanced income potential (Figure 1). This may bode well for non-cash returns, since income has primarily determined fixed income returns over time.¹ In addition, because non-cash sectors are sensitive to declining rates, price appreciation is possible once the Fed begins cutting rates. Positioning portfolios for an eventual rate decline helps take advantage of those return building yields now.

Starting yield ultimately drives fixed income returns

Because most fixed income returns over time come from income, attractive starting yields have been highly correlated with future total returns. See how the starting yield of the broad bond market has historically indicated total return over the next four years (Figure 2).

Non-cash fixed income sectors have two additional advantages in a declining rate environment:

Less volatile yields. Non-cash fixed income yields are more closely tied to intermediate-term rates, which tend to be more stable as the yield curve reshapes. Conversely, cash yields decline in lockstep with Fed rate cuts.

Non-cash fixed income sectors may experience price appreciation as rates decline because their duration is greater than cash, which is near zero (Figure 3). Recall that interest rates and bond prices move in opposite directions. For each 1% decline in interest rates, a fixed income asset should appreciate 1% for each year of duration, all else being equal. For example, if rates decline 1% over the next year, the broad bond market should appreciate (0.01 * 6.13 yrs = 0.0613 = +6.13%).

2024 fixed income investment themes

As we build portfolios, we are incorporating these main themes:

1. Higher current yields present the best starting point in 15+ years.
2. Higher-for-longer rates offer continued income opportunities.
3. Declining longer-term rates offer compelling total return opportunities.
4. Managing credit risk actively and selectivity is critical as the economy slows.
5. Diversification is paramount in uncertain markets.

Consider these investment ideas

Outlook

Credit spreads are likely to widen

We continue to expect growth to moderate moving forward, to a below-trend pace. The risk of outright recession in developed markets has receded substantially. Job growth will likely moderate further in the months ahead and presents upside risks to the unemployment outlook. Inflation has peaked but will likely remain “too high” relative to central banks’ targets this year. Nevertheless, the policy focus will likely shift from too-high inflation toward too-low growth.

We believe the Fed is done hiking rates, and we anticipate 50 bps of rate cuts this year. The European Central Bank has started cutting rates, and we anticipate a second cut later this year. In China, policymakers are likely to continue with their fiscal policy support, though substantial monetary easing is unlikely.

We continue to favor spread sectors and credit risk in asset allocation, with an up-in-quality bias within asset classes. We believe credit spreads are likely to widen in the coming months, presenting more attractive entry points for risk taking. That said, we see attractive opportunities in the preferred securities market and in BB rated high yield and senior loans. We do not see much further upside for long-end yields.