Neil Sun, CFA, Portfolio Manager for the BlueBay U.S. Fixed Income Team at RBC Global Asset Management, joined Keith Black, Managing Director of RIA Channel, to discuss positioning fixed-income portfolios in a time of uncertain monetary policy.
The dominant themes in the fixed-income market in the last three years have been inflation and Fed policy. Central banks rapidly raised rates in 2022 and the question this year is which central banks will be easing monetary policy and the speed at which they do so. Market expectations of how quickly these rate cuts will occur have increased volatility in the fixed-income markets. Increased fixed-income volatility has increased the opportunity for active managers to add value.
BlueBay’s U.S. fixed-income portfolios have benefited from strong positioning this year, with longer duration holdings during this year’s rate decline and the predictions that the yield curve would steepen and lose its inversion. Owning shorter-duration securities and selling short 30-year Treasuries benefits when the yield curve steepens. Shorter-term interest rates have been declining with the expectation for Fed rate cuts, while rates at the long end of the curve may stay higher for longer with expectations of term and inflation rate risk premiums. Fixed-income portfolio returns can be driven not only by the portfolio’s duration but also by changes in the shape of the yield curve.
While credit spreads are near the tightest levels in their historical range, active managers can still find value in some fixed-income credits. The BlueBay U.S. Fixed Income Team favors credits with wider spreads that can benefit from further compression in credit spreads. Sectors with wider spreads include subordinated debt and hybrid securities.
Even though both parties are likely to continue to increase deficit spending, the US election continues to contribute to expectations of interest rate volatility. A continued increase in Treasury issuance can drive down prices and increase yields at the longer end of the Treasury yield curve. The yield curve can continue to steepen as the Fed cuts rates and the Treasury continues to increase its outstanding debt.
While some investors expected as many as eight interest rate cuts by the US Fed in 2024, the BlueBay U.S. Fixed Income Team continually had an expectation that there would be just two to three cuts. Market expectations of the number of cuts have significantly declined and are now in line with the Team’s unchanged view.
Investor flows into fixed income have increased as the total return potential has increased. Returns can increase beyond the stated yield as interest rates decline. Investment grade credit has experienced strong investor demand in 2024.
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