June 2024 Investment Commentary
As daily liquid cash rates remain elevated around 5-5.5%, investors continue to pour assets into money market funds and other cash instruments, with money market fund assets passing $6 trillion this year, up from $4.5 trillion prior to the current Federal Reserve rate hike cycle. Some of this surge can be attributed to bank deposit outflows as deposit holders, particularly business corporate accounts, seek to earn higher yields than what they were earning on bank deposits.
The surge in money market fund assets can also be attributed to investors seeking safe harbor from the volatility experienced over the past two years. Despite investment grade fixed income returning over 5% in 2023, long-term rates continue to be susceptible to rate volatility as witnessed in the second half of 2023 with the 10-year Treasury rate rising as high as 5% in early October before settling down to 3.8% at the end of the year, and now back up to 4.40% in June.
However, fixed income markets are now seeing more disinflationary tailwinds than inflationary headwinds as various readings of core inflation progress towards the Fed’s long-term target of 2%. Even with the U.S. economy running above trend, powered by personal consumption and investments, and the unemployment rate running at near historically low levels, pricing across the bond market is indicating that the Fed is closer to cutting.
Although the market implied magnitude and pace of expected rate cuts differs from that of the Fed’s projections, the next couple of years we are expected to experience a new rate cut cycle.
Fixed Income Strategies Can Pay Off Over the Long Run
One may be surprised to find that locking in a lower rate for a few years compared to remaining in money market funds, despite their current higher yields, can pay off over the long run, especially if we see a dramatic drop in short-term rates as implied by market pricing.
Looking at the yield curve and available fixed income strategies, the most important factor to weigh is your client’s investment objective and time horizon. Align client spending time horizons with portfolio maturity schedules. Short-term spending needs are usually funded with short-term maturity instruments. If your clients don’t have short-term spending needs, you have an opportunity to lock in high inflation-adjusted rates over a longer time period.
*Source: Bloomberg. Data as of 6/10/2024. For illustrative purposes only. This analysis assumes 3-month annualized rates are realized as projected by SOFR interpolated pricing as of 6/10/2024 and a flat yield curve for the reinvestment of the 5-year Treasury Bond held to maturity.
The 3-month Secured Overnight Financing Rate (SOFR) serves as a valuable surrogate for gauging both current and anticipated money market fund rates. By examining the implications of diminishing yields, particularly when manifesting an inverted curve, as reflected in the SOFR curve, this table illuminates the consequential disparities in income generation. A comparative analysis is drawn between the income derived from the money market fund proxy and that emanating from a fixed 5-year maturity Treasury Bond*.
Initially, the income from the money market fund rates surpasses that of the 5-year bond, offering a higher return in the first/current year. However, the trajectory shifts, and the income from the money market fund proxy falls behind that of the 5-year bond. This disparity starts with the anticipation of lower interest rates, underscoring the need to look ahead as well as at current markets.
Conclusions
- Short-term cash instruments have greater reinvestment risk.
- Longer-term fixed income allows investors to lock in rates.
- Aligning investor time horizons with portfolio maturities helps address both reinvestment risk and total return risk resulting from interest rate volatility.
Guidance
Read our blog post 5 Steps to Restructuring Fixed Income Portfolio Duration.
Freedom Advisors has a diversified lineup of fixed income strategies including strategies that take on the management of duration and diversification, as well as specific duration and sector strategies. If you would like to discuss the fixed income markets or learn about our complete portfolio management solution, schedule an introductory call.
Advisory services are offered through Freedom Investment Management, Inc. (“Freedom”), a registered investment adviser. This is not an offer to buy or sell securities nor should it be relied upon as investment advice. Potential investors are advised to consult with their financial, tax and/or legal advisors prior to investing. All investments carry with it a degree of risk(s) which may include a total loss of invested assets.
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