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Fixed-income investors may want to consider making a few tweaks to their portfolio as the second half of the year gets underway. Despite earlier predictions of multiple interest rate cuts this year, the Federal Reserve has held the federal funds rate steady at 5.25%-5.50%. But the central bank is expected to start cutting rates in coming months, perhaps as soon as September. At its last meeting in June , the Fed signaled just one reduction before year end. However, many on Wall Street still believe two cuts are likely this year, including Charles Schwab. “There is room for them to cut rates because inflation is falling… [and] the labor market is cooling off,” said Kathy Jones, chief fixed income strategist at Charles Schwab. Both the price data and the jobs market are moving close to the Fed’s targets and real interest rates, after inflation, remain high, she added. Jones anticipates better returns for fixed income in the second half, but believes volatility will remain high. Therefore, finding the right mix of fixed income asset classes will be the key to performance, she said. Look to add some duration In this environment, Jones would start to think about adding some duration — in other words, going out in to longer maturities. “Look beyond Treasurys,” she said. While they remain a core holding, the potential gains from price appreciation appear limited with the yield curve still inverted, meaning when short-term rates are above those paid on longer-dated securities, she explained. In fact, there are plenty of opportunities to nab 5% yields for the intermediate- and long term without taking significantly more credit risk, Jones said. She specifically likes investment-grade corporate bonds and government agency, mortgage-backed securities in the six- to seven-year time frame for attractive yields and potential price appreciation. “We know the spreads are tight [in investment grade bonds], but we don’t see a big default cycle starting any time soon… where we worry about losing principle or a big downgrade,” Jones said. Investors can have a barbell portfolio with Treasurys on one end and investment-grade bonds and an agency MBS on the other, she suggested. They can also opt for a bond ladder, filling in the middle rungs of the ladder with investment-grade corporates and agency MBS, she said. JPMorgan also likes the barbell approach. The bank expects the yield curve to remain inverted through the end of 2024, but said the curve could be positively sloped by the end of 2025. The benchmark 10-year Treasury currently yields 4.259% while 1-year Treasury notes and under pay more than 5%. History shows that as a combination of looser monetary policy and/or slowing growth and inflation allows the curve to steepen, gradually extending duration has best served investors, JPMorgan said in its midyear outlook. “That said, the shallow path for rate cuts driven by normalizing growth and inflation suggests investors may be best suited embracing a barbell approach by generating still attractive yields at the front end, while owning some duration as a portfolio hedge,” the team wrote. Meanwhile, Wells Fargo is advocating that investors prioritize credit quality as the yield curve stays inverted over the next 6 to 18 months. “If this whole story in some ways ends somewhat with more economic pain before the Fed comes to the rescue, you want to be up in quality in your portfolio,” explained Sameer Samana, senior global market strategist at Wells Fargo Investment Institute. Right now, Wells Fargo prefers municipal bonds and securitized products, such as residential mortgage-backed securities . It finds high-quality residential MBS, including agency- and non-agency mortgages, attractive because of their relative value compared to investment-grade corporates. Meanwhile, muni bonds are a good investment for those in the highest tax bracket since they are free of federal taxes, Samana said. “Given all the talk about deficits and fiscal responsibility you could possibly see a scenario where at some point tax rates have to go up for more fiscal discipline,” he said, adding that it won’t happen anytime soon. Within munis, Wells Fargo likes state and local general obligation and essential service revenue.
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