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Fixed income

What goes up, must come down

Anders Persson
Chief Investment Officer, Head of Global Fixed Income
Tony A. Rodriguez
Head of Fixed Income Strategy, Nuveen
Taxable FI commentary

Key takeaways

With the U.S. Federal Reserve’s first rate cut in September, we have moved from a very long cycle of higher rates toward a likely slow path of rate cuts. We anticipate a series of 25 basis point cuts over the remainder of 2024 and into 2025. In this environment, extending duration and maintaining allocations to higher yielding credit sectors – with an eye toward quality – may make sense.

Long awaited rate cuts have begun

At its September meeting, the Fed started the cycle of interest rate cuts by lowering the policy rate 50 basis points (bps) and setting up several more cuts for later this year. The Fed’s current projections indicate that this cycle may be slow and long, more like the 1995 and 2000 easing cycles than more recent periods (Figure 1).

This easing cycle may be slow and long, more like the 1995 and 2000 cycles.
Many fixed income sectors offer more income than cash

 

Not all interest rate cycles are the same

For an idea of how this cycle may play out, we look to prior cycles similar to the current environment (Figure 2). For example, Fed cuts in periods 1 and 3 were due more to a slowing economy than a crisis situation. Conversely, cuts in more recent periods 4 and 5 were precipitated by extreme economic distress – the Great Financial Crisis and the global pandemic. Period 2 presented another crisis due to Russian and emerging markets debt market issues that caused hedge fund Long Term Capital to fail.

Attractive starting yields are highly correlated with future total returns

How did fixed income fare?

Since bond prices move in the opposite direction to interest rates, major bond sectors experienced positive returns in prior falling rate periods (Figure 3). Not surprisingly, the longer-duration investment grade corporate sector performed better, while the short-term, floating-rate loan segment fared worse. Outsized performance of emerging markets debt during 1995-1996 was partly due to a high concentration among a small number of Latin American countries. Importantly, all major sectors outperformed cash.

Non-cash sectors offer dramatically longer duration profiles

Positioning portfolios in today’s market

How should investors be thinking about portfolios in the current cycle? The basics of fixed income management still apply: build income, manage duration and pay attention to credit risk.

Emphasize diversified sources of portfolio income. Income has been the primary driver of fixed income returns over time.1 Since interest rates are relatively high, bonds currently offer generous yields. However, emphasizing sectors that may maintain higher income levels as rates slowly decline may help build total return.

We like the higher-quality credit sectors with more income potential, such as investment grade corporates, preferred securities and higher-rated segments of high yield corporates. As the economy slows, allocating across fixed income sectors may further diversify specific portfolio risks.

 

We like the higher-quality credit sectors with more income potential.

Lengthen portfolio duration. While many investors have been heavily weighted in cash, we think extending portfolio duration makes sense as rates fall. Increasing a portfolio’s duration, a common measure of a fixed income investment’s sensitivity to interest rate changes, helps improve price appreciation as rates decline.

We advocate moving toward the intermediateterm duration segment of the market. This allows the portfolio to benefit more from falling rates than cash or shorter-term investments without subjecting it to the relatively volatile swings of long-term investments.

Credit spreads are currently fairly narrow, and we believe spreads can remain reasonable for some time.

Balance credit risk. Credit spreads are the difference between the yield of a riskless U.S. Treasury bond and a security with credit risk, such as a corporate bond. At their essence, credit spreads represent a risk premium. During periods of economic contraction that cause rates to fall, market risk premiums typically rise. This widening of credit spreads negatively impacts bond returns, potentially offsetting some of the benefit of falling rates on asset prices.

Credit spreads are currently fairly narrow versus historical levels. We believe spreads can remain reasonable for some time because we are not in recession and corporate fundamentals remain solid. Other factors should reduce the amount of spread widening. Consider the high yield corporate market, for example:

  • Defaults are historically low and projected to remain low (Figure 4).
  • The high yield asset class is skewed toward higher quality, with nearly half of the outstanding debt rated BB and only about 12% rated CCC.2 High yield bond issuers have strong balance sheets even as we head into a potentially more challenging economic environment.
  • Falling rates may benefit companies, both in terms of cost and business model considerations. Lower interest rate expenses help the weakest borrowers, which are more likely to default. Banks experience increased margins as declining short rates reduce the interest rates they credit their customers.

Because spreads are tight and credit risk naturally increases as the economy slows, we like maintaining an up-in-quality bias. For example, stick to the less volatile investment grade corporate industries and emphasize the higher quality BBand B- rated high yield corporate segments

Non-cash sectors offer dramatically longer duration profiles

Employ multisector strategies. By allocating to strategies that use a wide range of sectors, investors may take advantage of relative value opportunities. Additionally, multisector strategies tend to have high correlations to the bond market and low correlations to equities, making them useful for offsetting stock market volatility.

  • Multisector bond strategies. The additional yield potential can help keep income levels high. In general, such strategies augment a base of diversified, higher-quality sectors with larger allocations (typically up to 50%) to belowinvestment grade securities. This approach offers more yield potential than core plus in return for greater potential volatility.
  • Core plus strategies. The ability to actively adjust allocations to lower-quality segments may boost yield while balancing overall risk. These strategies combine a larger portion of higher-quality sectors – like U.S. Treasuries, mortgage-backed securities and investment grade corporates – with smaller allocations (typically up to 30%) to lower-quality sectors, such as high yield corporates, senior loans and emerging markets debt.
  • Core strategies. These strategies invest broadly across bond market sectors, including U.S. Treasuries, securitized sectors and investment grade corporates. They tend to have the highest correlation to the bond market, helping balance the risks of equity allocations.

These strategies fared differently during previous Fed cutting cycles, but they all significantly outperformed cash (Figure 5).

By allocating to multisector strategies, investors may take advantage of relative value opportunities.
Many fixed income sectors offer more income than cash

Cash yields are set to decline

While it may be tempting to wait, cash yields will likely decline meaningfully in either a soft or hard landing scenario. It is just a matter of how fast and how much. Repositioning portfolios into longer duration sectors now may add income and provide additional returns as rates fall.

Many fixed income sectors offer more income than cash

Outlook


We favor an up-in-quality bias

U.S. economic growth should continue slowing to a below-trend pace. U.S. job growth is likely to moderate further and presents upside risks to the unemployment outlook. Inflation has peaked but should remain “too high” relative to central banks’ targets this year. Nevertheless, policy should remain focused on downside risks to growth rather than upside risks to inflation.

We expect the Fed to continue cutting interest rates 25 bps per meeting through mid-2025, bringing policy rates to the neutral level of 3.25%-3.50% by June. The European Central Bank is also set to cut rates further, and we forecast 125 bps of cuts through mid-2025. In China, policymakers will likely continue fiscal policy support, though substantial monetary easing is unlikely.

We continue to favor spread sectors and credit risk in asset allocation, with an up-inquality bias within asset classes. We believe credit spreads should widen modestly in the coming months, likely presenting attractive entry points for risk taking. That said, we see attractive opportunities in the preferred market, in BB-rated high yield and senior loans, and in non-core asset-backed securities and commercial mortgage-backed securities. Emerging markets should benefit from a weaker dollar, central bank rate cuts and steady global growth. The recent rate rally has moved in line with our forecasts, and we expect long-end yields to be range bound over the coming months.

Related articles
Weekly commentary Treasury yields continue marching higher with all eyes on the U.S. election
U.S. Treasury yields moved modestly lower last week, with the 10-year yield ending 2 basis points (bps) lower at 4.08%.
Fixed income The changing face of CLOs: reflecting on its evolution
The CLO market has moved into the mainstream and is appealing to new investors. Himani Trivedi, head of structured credit at Nuveen, reflects on its evolution in an expert Q&A analysis featured in private debt investor.
Fixed income Trends and opportunities in impact credit Q&A with Stephen Liberatore and Jessica Zarzycki
The fast-growing market for impact credit offers investors a rich source of opportunity and diversification.
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Endnotes

1. From 31 Jan 1976 to 31 Aug 2024, 100% percent of annualized total return of the Bloomberg U.S. Aggregate Bond Index was derived from coupon return, as opposed to price appreciation.

2. Data source: Bloomberg, L.P., Bloomberg U.S. Corporate High Yield Index, 31 Aug 2024.

Sources

Inflation: U.S. Bureau of Labor Statistics Consumer Price Index for All Consumers. Employment: Bloomberg, L.P., Bureau of Labor Statistics, Nuveen. Global debt and yields: Bloomberg L.P

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Performance data shown represents past performance and does not predict or guarantee future results. Investing involves risk; principal loss is possible.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on nuveen.com. Please note, it is not possible to invest directly in an index.

Important information on risk

Investing involves risk; principal loss is possible. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, derivatives risk, dollar roll transaction risk, and income risk. As interest rates rise, bond prices fall. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity, and differing legal and accounting standards. These risks are magnified in emerging markets. Preferred securities are subordinate to bonds and other debt instruments in a company’s capital structure and therefore are subject to greater credit risk. Certain types of preferred, hybrid or debt securities with special loss absorption provisions, such as contingent capital securities (CoCos), may be or become so subordinated that they present risks equivalent to, or in some cases even greater than, the same company’s common stock. Asset-backed and mortgage-backed securities are subject to additional risks such as prepayment risk, liquidity risk, default risk and adverse economic developments. Non-investment-grade and unrated bonds with long maturities and durations carry heightened credit risk, liquidity risk, and potential for default.

CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.

Nuveen, LLC provides investment solutions through its investment specialists.

This information does not constitute investment research as defined under MiFID.

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