Inflation, Interest Rates, and your Bond Portfolio

The bottom line

• Moderating inflation may allow the Fed to stop raising rates shortly, though we don’t expect it to lower them anytime soon.
• High interest rates create opportunities beyond cash: take advantage of high front-end rates while also locking in high rates for longer with longer-term bonds.
• Alternative investments with “cash plus” mandates may also be poised for success in these markets.

The back and forth of July

July was quite a month for bond investors as they mulled through strong jobs data, slowing inflation, and inconclusive comments from the Fed. In the first week, interest rates re-tested the year’s highs after a strong ADP National Employment report made it seem more likely that we’d see one or two more rate hikes before the Fed puts this cycle to rest, as Chair Powell suggested in his June press conference.

The second week of July brought a reversal in rate expectations upon the release of June inflation data. With the consumer price index (CPI) up only 3% year-over-year – a return to March 2021 levels – interest rates moved back down on hopes that the July rate hike might truly be the last.

The Fed met at the end of the month and, as expected, raised the federal funds rate to a 22-year high of 5.25-5.50%. Chair Powell emphasized that the Fed will be data dependent as it considers future interest rate policy. He also noted that if inflation starts coming down “credibly” and “sustainably,” the Fed will not have to keep the policy rate at today’s restrictive level.

Not to be outdone, August kicked off with more volatility. Fitch (one of the three major U.S. credit rating agencies) downgraded the U.S. sovereign credit rating from AAA to AA+ due to expected fiscal deterioration, growing government debt, and repeated debt ceiling stand-offs. Fitch also downgraded several government-sponsored entities including Fannie Mae, Freddie Mac and Farm Credit System. In our view, these rating downgrades are unlikely to sway Fed policy.

Instead, it will be critical in the coming months to keep an eye on inflation. One low print does not make a pattern, but multiple low prints may spell the end of this rate hiking program. We’ll get the next policy update from the Fed on September 20th, which may be largely driven by the two CPI updates to be released between the July and September meetings.

Rates are expected to remain near current levels through year-end
Range of economists’ forecasts for U.S. Fed Funds rate

If the Fed does pause rate hikes from here, we expect it to keep interest rates at current levels until inflation shows that credible, sustainable decline it is looking for. The path of inflation and health of the U.S. economy remain sizeable variables that could shift our view.

There’s more to fixed income than cash

Investing in cash instruments is like ordering your ‘go-to’ sandwich at your neighborhood deli. It satisfies your hunger and you know what to expect. Cash is the ‘comfort food’ for your portfolio. Indeed, the opportunity to earn 5% on cash is an attractive one, but it’s not the only one, and it won’t last forever. High interest rates create longer-term opportunities, too. Many want to expand their palate but they’re not sure when or how.

With the Fed at or nearing the end of its hiking cycle, now may be the time to fill up on fixed income. We recommend diversifying your portfolio across different types to potentially beat those appealing cash rates and keep the income coming beyond the here-and-now. Before you order ‘the usual’ again, take a look at what else is on the menu…

Yields-to-worst of select fixed income assets

Treat yourself to some ultra-short bonds. It wasn’t long ago that ultra-short fixed income was yielding 0%. Today, floating rate Treasuries have an average yield-to-maturity of 5.6%.¹ Earning more than 5% with little-to-no risk tastes pretty good!

A hearty serving of bond ladders can help you lock in high interest rates for longer. Bond ladders consist of a series of bonds that mature in consecutive calendar years. When the first bonds mature, the principal is reinvested in bonds maturing one year later than the longest maturity bonds in your ladder. The income you earn on your bonds is not the only benefit. As long as you hold the bonds to maturity, interest rate movements don’t matter: you get all of your principal back at the end.

The 5-year Treasury is currently yielding 4.2% — a significant difference versus its 1.26% yield at the end of 2021.² While short-term cash rates are attractive at the moment, they will eventually come down, and the ability to lock in 4%+ for five years might not last forever either. You can build bond ladders with individual bonds or term maturity ETFs, or you can buy them through an SMA. However you access them, bond ladders allow you lock in those higher rates for the duration of the bond.

The traditional favorites are tastier than ever. Core bonds are serving up high yields and if interest rates fall, they’ll be delivering market gains as well. The Bloomberg U.S. Aggregate Bond Index is currently yielding roughly 5% with a duration of 6 years.³ Therefore, a 1% drop in interest rates could lead to capital appreciation of 6% in addition to the 5% annualized yield. Double-digit returns on core bonds are nothing to sneeze at. No one knows when rates will fall, but when they do, you’ll be glad if you hold a core bond allocation in your portfolio.

Spice up your meal with “cash plus” alternative investment strategies. Some of these strategies invest in tactical opportunities using derivatives, which allow much of their capital to be maintained in instruments that earn the U.S. cash yield. That means these funds mechanically earn the cash rate in addition to potential outperformance from opportunistic plays. If you are looking for a way to try to beat cash rates while also diversifying your stocks and bonds, this could be it.

We are also intrigued by emerging market debt. EM central banks are further along in their rate hiking cycles than their developed market counterparts, potentially freeing them up to cut rates earlier. This, in combination with a weakening U.S. dollar, could create a tailwind for local-currency EM bonds.

Pick your portions

Wondering how to weight these exposures in a portfolio? It depends on your portfolio objectives and the other assets you’re investing in alongside your fixed income. A few rules of thumb:

• The sooner you’ll need your money back, the more you may want to allocate toward ultra-short bonds.
• The more equity you hold, the more you may want to allocate toward bond ladders or core bonds as diversifiers for your equity risk.
• The higher your return target, the more you may want to allocate tactically toward parts of the market that might be able to outperform like “cash plus” alternative investments and emerging market debt.

With so many options available, it’s a great time to invest beyond cash. BlackRock can help you construct well-diversified fixed income portfolios for your clients. Contact your BlackRock representative for more information or explore our online investment tools and resources.

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