The Fed may cut rates in 2024. What’s next for bond portfolios?

Key takeaways:

• Today’s market conditions suggest that it’s time to evolve your bond portfolio.
• Objectives should be your guide, with different ‘optimal’ portfolios depending on how much you care about income vs. total return and equity diversification vs. capital preservation.
• Elevated cash yields and stock/bond correlations suggest introducing diversifying alternatives into your “fixed income sleeve” toolkit.

We’re only a few months into 2024, and higher-than-expected inflation prints have shifted what seemed like a sure thing at the start of the year – a Fed pivot to interest rate cuts this summer – to a question mark, sending interest rates up and calling into question just how much duration exposure each portfolio really needs.

If you’re wondering what to do next, you’re not alone. Now may be the right time to evolve your portfolio for today’s markets.

High stock and bond correlation calls for a different approach

If you’ve been around long enough, you remember when bonds easily served three purposes in a portfolio. They could provide income (as the name suggests), diversify your equity risk, and preserve your capital. But it's been a long time since core bonds could do all three.

Over the past year, the correlation between the Bloomberg Aggregate Bond Index and the S&P 500 has been double its 10-year average (see chart below). High stock/bond correlations are challenging the ability of core bonds to diversify equity risk while elevated volatility puts bond valuations at risk. In this environment, core bonds can’t do everything they used to do. You’re going to need some additions to your toolkit to help spruce up your portfolios this spring.

Higher volatility and equity correlations challenge bond funds’ ability to do it all
Standard deviation and correlation to S&P 500 of the Bloomberg Agg Bond Index

For many investors, diversifying alternative funds – particularly those that have the potential to deliver returns above what cash is paying – are now playing a greater role in diversifying overall portfolio risk. Many of these have been able to deliver attractive returns with low correlations to both stocks and bonds albeit with higher risk.

Diversifying alternatives can have lower correlations to stocks than bonds
3-year correlations to the S&P 500 Index and Bloomberg Aggregate Bond Index

But that doesn't mean you should count out bonds entirely.

Fixed income strategies in the current rate environment

While the “when” of the Fed’s pivot to interest rate cuts has been called into question, expectations for the longer-term path of interest rates remain the same.

Expectations that the Fed will lower the federal funds rate target from the current range of 5.25-5.50% to a longer-run neutral target of 2.6% over the next several years creates potential for capital appreciation in rate-sensitive bonds. And although it’s not my base case, a recession – and accompanying deeper rate cuts – remains a possibility that portfolios could position against.

With today’s inverted yield curve, where you get your duration (or interest rate risk) may matter as much as the size of the allocation. We expect the belly of the curve – that 2-7 year space – to be more sensitive to shifting Fed policy than the long end. Additionally, we believe high U.S. debt loads will keep longer-term interest rates high, leading to less capital appreciation potential on the long end of the curve (barring a growth shock that spurs the Fed to significant action). 

Long-term rates have less room to rally when the yield curve is inverted
Average 12m change in Treasury yield following curve normalization + rate cuts

It is also worth noting that high absolute yields, coupled with our positive economic outlook, lead us to seek out opportunities in “plus” sectors – the higher yielding parts of the market such as high yield and emerging market debt that typically make up the “plus” of “core plus” bond strategies.

Building your “fixed income plus” portfolio

The best way to translate those market views into practice depends on client goals.

After all, what is considered “optimal” depends just as much on the investor’s goals and risk tolerance as it does on market conditions.

Income, equity diversification and capital preservation are all important, but different investors assign different levels of importance to each one.

Whether you’re building a new portfolio or renovating a fixer-upper, start by considering two questions:

1. What is more important for the client: total return or income?
2. Are you optimizing for equity diversification (reducing portfolio risk in an equity-heavy portfolio) or capital preservation (minimizing risk within the fixed income portfolio)?

Each combination of these client priorities requires a different combination of investments. Consider our ‘blueprint’ for potentially adjusting fixed income sleeves in today’s market environment.

A blueprint for “fixed income plus” portfolio construction

Portfolio goal: equity diversification

These diversification sleeves live inside equity-heavy portfolios and may belong to investors who don't particularly consider or need income. Total returns – and risk management – are important at the whole portfolio level, not just within the sleeve, which makes equity diversification (low correlations to equities) important. This is where diversifying alternative investments are playing a larger role in balancing equity risk.

As an example, our Target Allocation Hybrid with Alternatives 80/20 model portfolio has more than an 80% allocation to equities (given its overweight to equities as of 3/14/24). What makes up the ‘20’ side of the portfolio is almost an even split between bonds and alternative strategy funds, with a lot of the bond sleeve allocated to core bonds and longer-duration bonds that can position against recession risk. There is also a small allocation to the “plus” sector bonds that are typically higher risk and higher yielding, but which our portfolio managers feel comfortable with given their positive economic outlook.

The ‘20’ of our 80/20 model leans heavily toward diversifying alternatives
Allocation of the Target Allocation Hybrid with Alternatives fixed income sleeve

Portfolio goal: capital preservation

Portfolios that focus on capital preservation with a gearing towards total returns may be for investors who place a premium on risk management but are indifferent between generating returns via income or targeted gains realization.

Alternative strategy funds can play a large role here, too, though not necessarily as large as in the equity diversification bucket, since equity correlations are less important in a portfolio designed for capital preservation (instead, correlations to bonds will matter more). But you'll still want to build as diversified of a portfolio as possible while keeping risk below the expected return.

Our most conservative target allocation model has roughly a 10% allocation to diversifying alternatives, but also includes allocations to select credit assets with lower correlations to interest rates. In portfolios with lower allocations to equities, equity diversification becomes less important, while traditional bond diversification is very important.

Our more conservative models aim for balanced risks
Target Allocation Hybrid with Alternatives 0/100 allocation

Portfolio goal: equity diversification with income

Portfolios that seek equity diversification while earning income might be a fit for a retired investor who still has a healthy allocation to equities. They’re willing and able to take on some risk to allow their nest egg to continue growing (and improve the probability of it lasting through their retirement), but they also need the portfolio to provide income today.

These portfolios may take on less risk within their equity sleeves with a focus on higher quality dividend payers, allowing them to take on more credit risk within their bond sleeves to drive higher income. As an example, our Multi-Asset Income Moderate model has a roughly 50/50 allocation between stocks and bonds. The bulk of the equity sleeve is allocated to high quality dividend payers, while the bulk of the fixed income sleeve is allocated to a diversified portfolio of those same “plus” sectors with higher yields.

Produce income while balancing equity risk
Allocation of the Multi-Asset Moderate Income model portfolio fixed income sleeve

Portfolio goal: capital preservation with income

Now consider a portfolio for retired investors who need a steady flow of income to meet their spending needs and don't have the ability or inclination to take much risk. The goal is to maximize income per unit of risk, while keeping that risk budget low. Ideally, the expected risk, or standard deviation, of the portfolio would be lower than the expected yield.

With today's high yields, investors can build a high quality, low risk portfolio using short duration investment grade bonds. But time horizon is important. The Fed may start cutting interest rates later this year, and once interest rates come down, investors will need to take on more risk to drive the same amount of yield. Building in some "plus" sectors can diversify interest rate and investment grade credit risk while also providing extra yield while it's still available.

Our most conservative income model includes a diversified basket of bonds
Allocation of the Target Income Core Model portfolio

The bottom line

Fixed income markets may continue to evolve, but you can always count on two things to be relatively consistent: client objectives and the importance of risk diversification. We believe in the potential to drive outperformance in highly volatile, high dispersion environments, but the best chance for long-term success lies in setting up and maintaining diversified portfolios that are geared toward client objectives.

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