Investing Strategy: Moving Beyond Cash to Lock in Higher Rates

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Seeking Higher Returns

Lori Van Dusen, CEO and founder of LVW Advisors, suggests that given the six-month Treasury yield of 5.5% is near the S&P 500 earnings yield, it was an obvious choice to invest in nearly risk-free government bonds in the first half of 2023.

Venturing Along the Yield Curve

Financial advisors and bond market watchers advise investors to move beyond the perceived safety of cash and consider slightly longer-dated to intermediate-term bonds. By doing so, one can take advantage of higher rates. Even with the possibility of one or two more interest rate hikes by the Federal Reserve this year, the central bank’s aggressive rate-hiking cycle is likely coming to an end.

The Challenge of Timing

Janet Rilling, senior portfolio manager and head of the Plus Fixed Income team at Allspring Global Investments, recognizes that timing the “Goldilocks moment” of buying longer-dated bonds just before rate cuts by the Federal Reserve is difficult. Waiting too long could mean missing out when the rate cuts eventually come.

A Pre-Goldilocks Moment

Currently, the market is in a pre-Goldilocks moment, but the good news is that investors do not need to time rate cuts. Rilling’s research indicates that over the past 30 years of Fed rate cuts, investors have benefited from increasing their bond exposure between the peak of the 10-year Treasury note yield and the start of rate cuts. Rilling suggests that the 10-year note yield likely peaked in October at around 4.2%, whereas its current value stands at 4%.

Duration Matters

Rilling advises that this may be a suitable time to start adjusting the duration of one’s investments. Duration is a measure of interest-rate risk associated with a bond’s maturity, yield, and other factors.

30-Day SEC Yield

Portfolio Diversification in Fixed Income Investments

Introduction

When it comes to fixed-income portfolios, diversification is key. This allows investors to spread their risk across various assets and durations. Robert Gilliland, the managing director and senior wealth advisor at Concenture Wealth Management, understands the importance of this strategy. He advocates for diversifying fixed-income portfolios through a combination of duration and asset types.

Extending Duration and Yield

Gilliland achieves diversification by using different exchange-traded funds (ETFs) in his portfolios. To extend duration, he relies on the iShares 20+ Year Treasury Bond ETF (ticker: TLT). This ETF provides exposure to longer-dated Treasury bonds, which offer a cushion when the Federal Reserve eventually cuts rates.

To add yield and further diversify his portfolio, Gilliland includes the Vanguard Intermediate-Term Bond ETF (BIV) and the iShares 0-5 Year Investment Grade Corporate Bond ETF (SLQD). BIV is a mix of high-quality government bonds and investment-grade corporate bonds. On the other hand, SLQD consists of shorter-dated investment-grade corporate bonds. These shorter-dated bonds not only add yield but also contribute to portfolio diversification.

Cost-Effective Solutions

All three of the aforementioned ETFs are index funds, which means they have low annual expense ratios. The iShares 20+ Year Treasury Bond ETF has an expense ratio of 0.15%, while the Vanguard Intermediate-Term Bond ETF and the iShares 0-5 Year Investment Grade Corporate Bond ETF have expense ratios of 0.04% and 0.06% respectively. This makes them cost-effective options for investors seeking diversification in their fixed-income portfolios.

Gradual and Consistent Approach

For investors who are underweight in fixed income, Gilliland recommends gradually and consistently adding exposure to take advantage of potential changes in short-term rates. Rather than making sudden changes from short and ultrashort positions to owning a large amount of long-term bonds, he suggests an evolutionary approach. By slowly increasing exposure over time, investors can optimize their fixed-income portfolios without taking excessive risks.

A Popular Choice

The iShares 20+ Year Treasury Bond ETF has been a popular choice among investors. According to Steve Laipply, the global co-head of iShares fixed income ETFs at BlackRock, this fund has gathered $11 billion in assets this year through mid-June. Its popularity reflects the demand for long-dated Treasury bonds as a means of diversification in fixed-income portfolios.

Conclusion

Diversifying fixed-income portfolios is essential for risk management. By spreading investments across different durations and asset types, investors can create a well-rounded portfolio. Robert Gilliland’s strategy of using index ETFs with low expense ratios is an effective and cost-efficient way to achieve diversification. Additionally, adopting a gradual and consistent approach allows investors to take advantage of potential changes in short-term rates without making drastic portfolio adjustments.

Investing in the Shorter End of the Yield Curve

According to Gregory Peters, managing director and co-chief investment officer of PGIM Fixed Income, investors are advised to focus on the shorter end of the yield curve, which is defined as 10 years or less. Peters does not anticipate any rate cuts from the central bank in the near future due to persistent inflation.

In this current stage of the economic cycle, Peters suggests avoiding the temptation to take on significant credit risk by extending duration or venturing further on the curve. While he doesn’t advocate for an ultra-short or cash position, he believes there is no compelling reason to do so.

Navigating Uncertain Times with High-Quality Bonds

With the uncertain economic environment, both Peters and Rilling urge caution when it comes to credit. They recommend sticking with high-quality bonds in order to mitigate potential risks. Additionally, they both utilize certain structured and securitized products that have proven to be successful in 2023.

Leveraging Structured Products through Bond Funds

Many financial advisors are utilizing a combination of actively managed and indexed bond funds to gain exposure to structured products. One popular choice among advisors is the well-regarded Pimco Income fund (PONAX), which has showcased strength in the nonagency mortgage-backed securities market.

The Pimco fund holds 39% of its holdings in government bonds and 21% in securitized bonds. With a three-year effective duration, it offers a favorable option for investors if the Fed maintains higher rates. Furthermore, it boasts a 12-month yield of 6.7%, making it a desirable choice. The expense ratio for the fund is 0.91% annually.

Portfolio Strategies for Bond Investors

1. High-Quality Blend: Pimco and Vanguard

One strategy favored by experts like Jane Van Dusen, a seasoned investor, is to combine the Pimco fund and the Vanguard Total Bond Index fund (VBTLX). The Vanguard fund, with an effective duration of 6.5 years, is particularly attractive if the Federal Reserve decides to cut rates. Van Dusen highlights the fund’s well-balanced portfolio of high-quality credit, short-to-intermediate term Treasuries, and agency bonds. With a minimal expense ratio of 0.05% and a solid 12-month yield of 2.75%, this selection offers stability and growth potential.

2. Actively Managed Flexibility: MetWest Total Return Bond

Derek Pszenny, a managing partner at Carolina Wealth Management, advocates for the MetWest Total Return Bond fund (MWTRX) as a core bond fund option. Pszenny believes that active management provides more agility in these uncertain times compared to index-based ETFs. The MetWest fund boasts an effective duration of 6.9 years and an impressive 3.4% 12-month yield. Its focus on securitized bonds, with a sector allocation of 47%, differentiates it from its peers. The expense ratio comes in at 0.65% annually.

3. Lower Interest-Rate Risk: Short-Term Focus

Matt Dmytryszyn, the chief investment officer at Telemus Capital, adopts a cautious approach by minimizing interest-rate risk. He recommends a combination of the SPDR Portfolio Short Term Treasury ETF (SPTS) and the PGIM Short-Term Corporate Bond (PSTQX). With an effective duration of 1.88 years and a yield of 2.13%, the SPDR ETF is ideal for Dmytryszyn’s strategy. The actively managed PGIM fund, with an effective duration of 2.67 years and a yield of 3.12%, focuses on 80% investment-grade bonds and 16% structured products. Dmytryszyn believes that the high-quality collateralized loan obligations and commercial mortgage-backed securities held by the fund provide additional yield-boosting potential. Both funds have low expense ratios of 0.06% and 0.38% respectively.

In conclusion, bond investors have various strategies to choose from to weather the economic uncertainty. Whether it’s combining high-quality funds, opting for active management, or focusing on short-term bonds, the key is to align the investment approach with individual risk tolerance and long-term financial goals.

Tax-Sensitive Investors and the Municipal Bond Market

Tax-sensitive investors should not overlook the potential opportunities that lie within the municipal bond market. Just like Treasury bonds, the muni-bond curve is inverted, with short-dated bonds offering higher yields compared to long-dated bonds. Stephen Tuckwood, the director of investments at Modern Wealth Management, highlights this important development.

To efficiently incorporate municipal bonds into investment portfolios, Tuckwood recommends iShares’ iBond ETFs as a diversified and effective option. These investment-grade muni bond ETFs come with defined maturities and regular income distribution. Tuckwood personally adheres to a duration of five years or less and aims to evenly distribute the weight across each year in the ladder.

For instance, by utilizing the iShares iBonds Dec 2023 Term Muni Bond ETF (IBML), iShares iBonds Dec 2024 Term Muni Bond ETF (IBMM), and iShares iBonds Dec 2025 Term Muni Bond ETF (IBMN), one can achieve a blended 30-Day SEC yield of 3.02%. Depending on an individual’s state and tax bracket, this translates to a tax-equivalent SEC yield of 5.33%.

Tuckwood emphasizes that utilizing iShares’ iBond ETFs provides all the benefits of a traditional bond ladder but with the added convenience of an ETF.

Additionally, BlackRock’s Laipply advises investors to not fret excessively about pinpointing their ideal duration sweet spot. Instead, they should focus on incorporating fixed-income holdings if they have not done so already. Due to the tightening cycle, there has been an incredible opportunity for investors as yields have been repriced.

By taking advantage of these developments in the municipal bond market, tax-sensitive investors can make informed decisions and potentially reap the rewards.