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With the second half of the year now underway, investors may want to take another look at their fixed income portfolio. High yields have been a boon to income investors, as the Federal Reserve increased interest rates over the past year. The ramp up, which began in March 2022 in an effort to tame inflation, has pushed yields higher on assets like U.S. Treasurys: The rate on the the 6-month T-bill is hovering just below 5.5%, while the 2-year note is at about 4.7%. Yields on certificates of deposit, money market funds and preferred securities have also seen a boost. US2Y US6M YTD line Yields on the 2-year Treasury and the 6-month T-bill Now the market is looking at the prospect of the Fed approaching the end of its hiking campaign. Policymakers indicated at their June meeting that two more quarter-point increases are on the way before the end of 2023. Indeed, traders anticipate another quarter-point increase next week. Inflation appears to be cooling with consumer and producer price increases coming in lighter than expected in June. “With regard to fixed income, I think all eyes are on the Fed, and it seems like the inflation data is getting more and more benign with each monthly report,” said James Franke, managing director at Rothschild Investment. Adding duration Moving into longer-dated issues allows investors to lock in higher rates, as the interest rate environment begins to normalize. Sonal Desai, portfolio manager and chief investment officer at Franklin Templeton Fixed Income, sees some upside in Treasury rates ahead, but believes those increase will soon be coming to an end. She’s moved to neutral in duration — a measure of interest rate risk — and is looking to extend it as the second half progresses. “We’re getting closer to the point that the U.S. 10 year ‘s [yield] is going to get closer to peak,” she said. “We do want to be long duration then. It’s not because we anticipate the Fed is embarking on a series of rate cuts … I, instead, believe we are getting ready to enter a more traditional fixed income market, where you will get lower returns” in the income component. Right now, Desai thinks investment-grade corporate bonds offer very healthy returns. As she increases duration, she’ll remain relatively high in quality, she said. See below for a list of bond exchange-traded funds with a duration of roughly six years. “Now might be the time to lock in with the anticipation the Fed could be done raising rates or cutting rates at some point in the future,” said Franke. Holding large concentrations of assets in short-dated Treasury bills leaves investors open to reinvestment risk once the central bank dials back its policy stance. He said that Rothschild has gone out as far as 15 to 20 years in municipal bonds due to their lower risk profile. They also generate income that is free from federal taxes — and are free of state levies if the investor resides in the state where the bond was issued. For investment-grade corporate bonds, the longest Franke’s firm has gone out is seven years. “We’re probably a little less positive on investment-grade corporates,” he said. “We feel that for incremental yield, you’re not getting compensated enough to take the additional credit risk.” Keep quality in check Recession is the last thing investors want to think about, but now is a good time to snap up some portfolio cushioning at a lower cost. “Treasury prices are rarely this low,” said Callie Cox, investment analyst at eToro. “Based on prices being so low, it can be attractive to look at them as that sanity hedge, that protection in a recession.” Bond yields move inversely to prices. In a recessionary environment, Treasury prices will rise as investors flock to safe assets, which can help lift investors’ portfolios and help offset any decline in equities. Franke, meanwhile, has steered away from chasing yield, opting instead for safety. “For more of our clients, we’re looking to have the fixed income of the portfolio provide lower correlation and income,” he said. “Right now, those boxes are checked more efficiently in Treasurys, municipals and securities that are less risky and less correlated with stocks.” Aside from longer-dated municipals, Franke’s firm has also liked adding holdings in the short end of the Treasury yield curve, “where you can get 5% or more in interest lending to the U.S government in Treasury bills and notes.” Evaluate your asset mix and timeline Check in with your risk appetite and make sure that your bond allocation reflects your goals and your timing for the money. Greg Wilensky, head of U.S. fixed income at Janus Henderson Investors, generally prefers securitized assets such as asset-backed and mortgage-backed securities. Wilensky sees “tremendous opportunity” right now to add yield and carry without adding a lot of risks. “You can stay [at the] fairly short end of the yield curve, high credit quality and get incremental yield,” he said. Individual investors who had been reaching for yield may want to reevaluate their holdings and ensure they are prepared to handle a downturn in the market later in the year or early next year. “You can’t think of high yield bonds in the same thought as Treasurys,” said Cox of eToro. “Consider shortening your time frame if you’re in high yield, or take some of that money off the table and put it into more conservative bonds.”
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