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The Fed will announce its decision on the benchmark rate today.
Oliver Douliery/AFP/Getty Images
As interest rates approach a likely peak, now is the moment for bond investors to venture beyond short-term cash to longer maturities, experts say.
The Federal Open Market Committee on Wednesday afternoon lifted its benchmark rate by 0.25 percentage point. Investors will be watching to see whether Federal Reserve Chairman Jerome Powell offers any thoughts about the trajectory of inflation and the health of the labor market, which will determine whether officials increase rates again before the end of the year.
The majority of investors now expect Wednesday’s rate increase to be the last of the current cycle, according to CME FedWatch Tool. Either way, the playbook is shifting for bond investors, experts say.
“This is an opportunity to come out of cash, take on more duration and lock in yields,” says Jonathan Rocafort, managing director, head of fixed income at Parametric Portfolio Associates.
To be sure, cash has been a lucrative place to park over the past year, and that won’t change overnight. Yet when rates eventually begin to fall, investors in short-term vehicles face reinvestment risk—that is, the risk that when their investment matures, they’ll have to reinvest that money at lower rates.
To guard against reinvestment risk, investors should begin to extend their exposures across the yield curve, says Marina Gross, co-head of Natixis Investment Managers Solutions.
“Your best defense is not to do it all at once, but to start bulleting out the curve,” Gross says.
It might seem counterintuitive to extend maturities when the Treasury yield curve is inverted, which it is now. Investors are not compensated with additional yield for tying up their money in a 10-year bond, versus a two-year note.
Yet this move has advantages. In addition to protecting against reinvestment risk, it will also help insulate investors in the event of a recession, Gross says. Once the market starts to sense a recession is near, investors will likely flock to the safety of bonds, pushing prices up and yields down. That rally should be a boon to investors who already own longer-duration bonds, which tend to be the most sensitive to changing interest rates, she says.
For now, all signs point to a Fed pause, where policy makers leave rates as is after a July hike as they watch data to determine whether inflation has come down to their target. Over previous tightening cycles, intermediate and longer-term bonds tended to outperform cash 12 months after the last rate hike, according to an analysis by Parametric Portfolio Associates.
“The pause scenario is very good for fixed income,” says Rajeev Sharma, managing director of fixed income for Key Private Bank.
Write to Elizabeth O’Brien at elizabeth.obrien@barrons.com