Bond investors may want to consider making some adjustments to their portfolios as the second half of the year begins. Despite expectations of multiple rate cuts this year, the Federal Reserve has kept the federal funds rate unchanged at a range of 5.25% to 5.50%. However, the central bank is expected to start cutting rates in the coming months, as early as September. At its last meeting in June, the Fed hinted at only one rate cut by the end of the year. However, many on Wall Street, including Charles Schwab, still believe that two rate cuts are expected this year. “Inflation is falling, so there is room for rate cuts… [and] “The labor market is cooling off,” said Cathy Jones, chief fixed income strategist at Charles Schwab. Both price data and the job market are nearing the Fed’s targets, and real interest rates, after adjusting for inflation, remain elevated, she added. Jones expects bond returns to improve in the second half of the year, but volatility will remain elevated. As such, finding the right mix of fixed income asset classes will be key to performance, she said. Consider adding duration In this environment, Jones will start to consider adding duration, or longer maturities. “Look beyond Treasuries,” she said. While Treasuries remain a core holding, the potential gains from price appreciation appear limited because of the persistent inverted yield curve, where short-term interest rates exceed interest rates on long-term bonds, she explained. In fact, there are plenty of opportunities to earn a 5% yield over the medium and long term without significantly increasing credit risk, Jones said. She particularly likes investment-grade corporate bonds and agency mortgage-backed securities with six- to seven-year terms because of attractive yields and the potential for price appreciation. “I know the spreads are tight. [in investment grade bonds]”But we don’t see a big default cycle starting anytime soon that would worry us about principal losses or major downgrades,” Jones said. Investors could have a barbell portfolio with Treasuries on one end and investment-grade bonds and agency MBS on the other, she suggested. They could also choose a bond ladder and fill the middle rungs of the ladder with investment-grade corporate bonds and agency MBS, she said. JPMorgan also favors the barbell approach. The bank said it expects the yield curve to be inverted through the end of 2024, but that the curve could be positively sloping by the end of 2025. The benchmark 10-year Treasury note currently yields 4.259%, while the one-year Treasury note is more than 5% lower. History shows that it’s best for investors to extend duration gradually, as a combination of loose monetary policy and slowing growth and inflation can make the curve steeper, JPMorgan said in its midterm outlook. “Nevertheless, the shallow path”The potential for rate cuts due to growth and inflation normalizing suggests investors are best served by adopting a barbell approach that still produces attractive yields in the early stages while holding some duration as a portfolio hedge,” the team wrote. Meanwhile, Wells Fargo argues that investors should prioritize credit quality as the yield curve will remain inverted for the next 6-18 months. “We would want to be in a position of quality in our portfolio if this situation ends with some form of further economic pain before the Fed rushes in to rescue us,” explained Samir Samana, senior global market strategist at Wells Fargo Investment Institute. Currently, Wells Fargo favors securitized products such as municipal bonds and mortgage-backed securities. The firm finds high-quality mortgage-backed securities, including agency and non-agency mortgages, attractive for their relative value compared to investment-grade corporate bonds. Meanwhile, municipal bonds are a good investment for those in the highest tax brackets because they are exempt from federal taxes, Samana said. “Given the discussion about deficits and fiscal responsibility, there is a scenario where at some point we are forced to raise tax rates to enforce fiscal discipline,” he said, adding that it’s not likely to happen anytime soon.Among municipal bonds, Wells Fargo likes state and local general obligation and essential services revenues.
How Wall Street will perform in bonds later this year
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