Investors are currently holding $6.1 trillion in money market funds, signaling a record level of cash on the sidelines. The possibility of higher long-term bond yields or lower money market rates could potentially lead to this cash finding a new home in bonds. Interest rates are rising once again, with the benchmark 2-year Treasury yield approaching 5% and the 10-year Treasury yield above 4.5%. Recent data and inflation expectations suggest that inflation rates will remain above the Federal Reserve’s target of 2%.
The reassessment of the Fed’s future monetary policy path has led to a shift in expectations for the Fed Funds Rate, with market data suggesting only two rate cuts for the rest of the year. This has caused interest rates to climb, presenting an opportunity for investors. While staying on the sidelines with money market funds or short-term T-bills offering high yields may seem attractive, it is suggested that investors enter the bond market slowly and cautiously.
The current interest rate environment is the highest it has been in 16 years, making real yields attractive for investors. High-quality corporate and municipal bond yields are also above those of comparable Treasuries. While there is a risk of rates drifting higher due to recent inflation trends, the high interest rates offered by bonds act as a cushion against potential negative price movements. Break-even scenario analysis can help investors estimate how high rates would have to move before negatively impacting bond returns.
By using break-even scenario analysis, investors can calculate the future price return of bonds based on changes in yield. Bonds’ total return consists of price return and income return, with duration measuring the expected change in bond price given a yield change. By estimating the break-even rate movement, investors can determine how high rates would need to move before expected bond returns become zero. If rates move above this level, it would lead to negative total returns.
For investors who are underweight in bonds or holding excess cash, the high yield cushion provided by high-quality bonds should offer comfort when considering an allocation to bonds. The significant amount of cash held in money market funds can act as a stabilizer for bond prices. It is important for investors to consider taking advantage of the current rate environment at a measured pace, rather than rushing into bonds. While there is potential for the first cut in interest rates to be pushed farther out, it is advised to consider a marginal increase in high-quality bonds rather than a significant shift in asset allocation. Each investor’s unique circumstances, risks, objectives, and tax considerations should always be taken into account before making any investment decisions.
