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How to Position Your Bond Portfolio with Rate Cuts on the Horizon

The bond market is a boring place … until it isn’t.

In 2008, the Federal Reserve’s rate cuts sent bond prices soaring — a rally that lasted until 2020. After post-COVID inflation sent interest rates sharply higher, bond prices fell more than 20% as 10-year Treasury yields pushed past 5% for the first time in decades.

Now, with inflation falling below 3% in July and the economy slowing, the Federal Reserve could be looking to cut interest rates sooner rather than later. And that could have a significant impact on your bond (and stock) portfolios over the coming months.

In this article, we’ll cover how far rates could move, the impact rate cuts have on bonds, and the steps you can take to better position your portfolio.

Rate Cuts on the Horizon

The financial markets are pricing in a high probability of rate cuts in the near future.

That’s because Federal Reserve Chair Jerome Powell strongly hinted at upcoming interest rate cuts in his keynote address at the central bank’s Jackson Hole retreat, saying that “the time has come for policy to adjust.” The goal is to engineer a soft landing for the economy by balancing concerns of upcoming economic weakness with any signs of inflation rearing its head again.

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The market expects rates to fall sharply between now and December 2024. Source: CME FedWatch

As of August 27, the CME FedWatch projects a 63.5% chance that the federal funds rate will fall from the current 525-550 basis point range to a 500-525 range in September’s meeting. By December’s meeting, the market sees a likely range of 425-450 basis points. These expectations suggest a significant shift in monetary policy is on the horizon that could impact all kinds of investment portfolios.

How Rate Cuts Impact Bonds

Falling interest rates favor existing bondholders but could hurt bond allocations.

Consider a scenario in which you have an existing bond portfolio and yields begin to decrease. The bonds you already own, which were issued at higher interest rates, become more attractive to investors. This increased demand drives up the price of these bonds, resulting in a capital gain for you as the bondholder (should you choose to sell your bonds and not keep the higher income).

However, the picture is different for new bond purchases in a falling rate environment. Any new bonds you acquire will come with lower yields attached to them, which translates to less interest income and potentially lower overall returns. The only silver lining is that if yields continue to fall, even these new, lower-yielding bonds could increase in value — but that’s hard to bet on.

How to Position Your Portfolio

You may want to consider adjusting your portfolio to mitigate these impacts.

First, consider locking in today’s relatively high yields using certificates of deposit (CDs). Most advisors recommend six months of expenses in savings, and CDs are an excellent way to secure current yields before rates potentially decrease. The idea is that you could lock in a higher interest rate at the same time inflation continues to fall, resulting in a positive net impact on your savings account.

Another crucial strategy is to match your bond fund’s duration with your expected holding period.

Short-Term Bond Funds

If you have a short investment horizon, it’s advisable to focus on short-term bond funds looking no more than three years out.

These funds are sorted by their YTD total return, which ranges from 3.6% to 5.4%. They have AUM between $35M and $9.61B, with expenses running between 0.30% and 0.40%. They are currently yielding between 4.4% and 5.3%.

Intermediate-Term Bond Funds

For those with a longer investment timeline, intermediate-term bond funds may be more appropriate. This approach can help mitigate future interest rate risk.

These funds are sorted by their YTD total return, which ranges from 3.3% to 5.2%. They have AUM between $330M and $7.8B, with expenses running between 0.03% and 0.25%. They are currently yielding between 3.2% and 3.8%.

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Equity valuations are already at a premium, meaning a slowdown could lead to a painful correction. Source: Multpl.com

Finally, it’s worth considering the broader economic implications of falling interest rates. While rate cuts are generally positive for the economy since they lower borrowing costs and incentivize spending, they often signal that the Federal Reserve perceives weakening economic conditions. So, it might make sense to incorporate defensive or dividend-paying stocks into your portfolio.

The Bottom Line

Positioning your portfolio in anticipation of rate cuts requires a thoughtful and strategic approach. By understanding the impact of rate cuts on bond (and stock) prices, locking in current yields where appropriate and matching bond duration to your investment horizon, you can better prepare your portfolio for the changing interest rate environment and mitigate potential risks.

As always, it’s important to consider these in the context of your financial goals and risk tolerance. And financial advisors can help provide personalized guidance in navigating these complex market conditions.

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Sep 03, 2024