Fixed Income Portfolio Strategy – Past and Present

Tom Beilstein, CFA, Portfolio Manager
Tammy Vargo, Fixed Income Research Analyst

What have we done?

In anticipation of a gradual transition from an expansionary Fed policy to one of contraction, Bill Few Associates, Inc. has made three major changes to our portfolios as warranted by our research. First, we further shortened the maturity and duration of our portfolios, moving assets from intermediate-term bond categories into short-term bond categories. Second, we added floating-rate bond funds to our core portfolios. Third, we added several defensive options to our fund list in the stable value and ultra-short bond fund categories. Each of these moves was defensive in nature, in order to better position our portfolios for an eventual rate rise.

What is next?

We believe that the measures we implemented remain appropriate at this point in time. However, after the tightening cycle is well under way, it may be prudent to begin to lengthen the duration of our portfolios a bit, stepping out to take advantage of the higher yields. We all know that rates will peak at some unpredictable level in the future. That level is the point at which all investors hope to jump in and lengthen their portfolios, before yields begin their descent once again. Unfortunately, we do not have a crystal ball to predict that level. Instead we have access to a number of good resources in an attempt to discern when rates are approaching their peak. One of these resources, Ned Davis Research (NDR), offers the following insights:

In the old days, yields peaked at or after the (tightening) cycle was over. The Fed did a poor job of communicating what it was thinking, so investors were always uncertain as to whether the Fed was finished hiking rates. In recent years, however, the Fed has made transparency an important policy goal. Bond investors now have a better sense about the Fed’s intentions and thinking. Once investors sense the Fed will remain vigilant, not let the economy overheat, or inflation get out of control, they become emboldened to take advantage of attractive yields. As a result, in the past two cycles 10-year yields have peaked 3-4 months before the cycle has ended.

According to NDR, on average, at the start of a tightening cycle, 10-year Treasury bond yields already have 1/3 of the rise in rates priced in before the actual tightening takes place. In the past three cycles, investors’ anticipation of higher rates is even more apparent, with 54% of the yield rise already priced into the 10-year Treasury before the first increase in rates. Today, with yields having risen about 1.6% from their low, NDR expects yields to rise another 1.0% or more in this tightening cycle.

From this analysis, we have gleaned two important points: 1) Historically, the yield on the 10-year Treasury tends to peak three to four months before the Fed is done raising short-term rates. 2) A substantial portion of the increase in rates has already occurred. With this knowledge, we look to return our portfolios to a more traditional allocation at some point in the middle of the tightening process. We believe the timing of this move will become more apparent as the yield on the 10-year Treasury moves closer to 6.0%. At this juncture, it appears that the Fed will take a gradual approach to raising short-term interest rates beginning at the end of June. In this light, we do not foresee the need for any sudden changes to our portfolios and will eventually make adjustments in measured steps.