As reinvestment risk emerges, how should investors navigate market uncertainty?

After aggressively raising interest rates 11 times between March 2022 and July 2023, the U.S. Federal Reserve (Fed) took a lengthy pause―the second longest on record, surpassed only by the pause from June 2006 to September 2007, which lasted 446 days. In recent months, the Fed’s rhetoric has begun to shift, suggesting that this phase might be nearing its end. In last month’s speech from Jackson Hole, Chair Jerome Powell noted that “the time has come for policy to adjust.” This statement set the stage for the September Federal Open Market Committee (FOMC) meeting, where the Fed lowered the benchmark interest rate by 50 basis points—its first rate cut since March 2020.

How quickly will the Fed cut rates?

Despite inflation remaining slightly above the central bank’s target, signs have emerged that the Fed’s restrictive policy stance might be putting too much pressure on certain segments of the economy. The labor market, which had demonstrated remarkable resilience throughout the tightening cycle, has started to show some cracks. The growth of new jobs is slowing while the unemployment rate has ticked higher. Other economic indicators, such as manufacturing Purchasing Managers' Index (PMI) and construction spending, are also signaling that a slowdown may be on the horizon.

The Fed’s policy pivot has brought the issue of reinvestment risk to the forefront for investors. Rising yields, coupled with bond market volatility driven by persistent inflation, have kept many investors on the sidelines, opting for the safety of cash to reap now-attractive yields as they wait for clarity around the market outlook. This cautious sentiment is reflected in the fact that money market fund assets have increased in tandem with the Fed’s benchmark rate.

Source: Macrobond, as of 8/30/24.

With a new monetary easing cycle upon us, investors will likely anticipate that these falling yields will quickly be reflected in money market and certificate of deposit rates. This shift is likely to prompt the substantial level of assets currently held within these cash-like products to seek out new investment opportunities. For now, however, many investors seem to still be on the fence about when and how to reenter the market.

Although the Fed has managed to curb inflation without triggering a sharp rise in unemployment so far, it’s still too early to tell if the central bank will ultimately be able to achieve a soft landing. In today’s late-cycle environment, we believe the elevated level of economic uncertainty creates a prime opportunity for actively managed funds that can add value through bottom-up security selection. 

Finding a more consistent source of alpha

Although active managers often use a top-down approach, positioning the portfolio for an expected change in interest rates by shifting duration, our investment philosophy is grounded in the belief that consistently getting these calls right is extremely challenging. Instead, we believe that remaining duration neutral while strategically taking advantage of changes in the shape of the yield curve can provide a more predictable and repeatable source of alpha within the portfolio.

We’ve observed a bull steepening of the yield curve year to date, with short-term yields falling faster than long-term rates, a scenario commonly seen in rate-cutting cycles. Historically, intermediate bonds have typically outperformed short and longer maturity bonds during such periods. 

Source: Bloomberg, as of 8/31/24. Returns greater than one year are annualized. Yield curve belly performance is represented by the Bloomberg U.S. 5–7 Year Treasury Bond Index. Yield curve wing performance weighs the blended Bloomberg U.S. 1–3 Year Treasury Bond Index and Bloomberg U.S. 25+ Year Treasury Bond Index to match the duration of the Bloomberg U.S. 5–7 Year Treasury Bond Index. Index definitions may be found in disclosure. Past performance does not guarantee future results.

By comparing the duration-neutral performance of the belly and the wings of the yield curve, we can see why positioning the portfolio to rely solely on the direction of interest rates can miss the nuances of how the shape of the yield curve will shift in response to monetary policy adjustments. As we enter the next phase of the monetary policy cycle, we expect the yield curve to steepen further due to the varying factors that affect short- and long-term yields. In this environment, yield curve positioning strategies such as allocating to the belly of the yield curve may offer active managers an additional lever to add value for investors.

Positioning defensively with agency MBS

We continue to see value in certain pockets of the market, including agency mortgage-backed securities (MBS). When investing within this space, it’s important to recognize that the MBS market isn’t homogenous. Active managers can add significant value by pinpointing specific areas with the potential to outperform, such as higher-coupon mortgage pools. Since these higher-coupon pools make up only a small portion of the Bloomberg U.S. MBS Index, active managers can tilt toward certain mortgage pools to generate higher levels of income while simultaneously protecting against prepayment risk.

Source: Bloomberg, as of 8/31/24.  It is not possible to invest directly in an index. Index definitions may be found in disclosure.

Prepayment risk is a key concern within this segment of the market when interest rates are declining and homeowners become more likely to refinance their mortgages at lower rates. Experienced management teams can employ several strategies to mitigate these risks, increasing the potential for the portfolio to maintain higher yields even as interest rates fall.

Given the current monetary policy backdrop, we believe that agency MBS present a clear opportunity for active management to add value, capitalizing on attractive valuations while leveraging the defensive nature of this segment within a late-cycle environment.

Managing reinvestment risk with active management

For investors concerned about reinvestment risk and looking to reenter the market, an actively managed strategy offers the flexibility to adapt to a dynamic market as monetary policy switches gears. With the peak for yields in this cycle now behind us, we believe that investors should consider moving off the sidelines, leveraging an active approach that has the flexibility to navigate shifting market conditions.