The U.S. Federal Reserve (Fed) just cut the federal funds rate a quarter point, to between 2.00% and 2.25%, representing the first reduction since the end of 2008, when the Fed effectively pinned short-term yields to the floor.¹
While that extraordinary moment would mark the beginning of seven lean years for money market funds, U.S. rates don’t appear poised to revisit zero anytime soon. Still, expected returns across savings accounts, certificates of deposit, and short-term bonds are likely to fall. Since the opportunity cost—the loss of potential gain from another alternative—of holding these and other quasi-cash instruments is likely to rise, long-term investors may wish to consider shifting a portion of their capital somewhere else. But where might those proceeds be redeployed? Bond market history may offer a pair of clues.
Bond market history lesson 1: duration has done well in easing cycles
In adjusting the level of the federal funds rate, the Fed directly controls the short end of the yield curve, but its actions have historically had implications for intermediate and longer parts of the curve, too. The last two rate-cutting cycles, which began in 2001 and in 2007, offer cases in point. In each instance, the yield on the 10-year U.S. Treasury note drifted downward just prior to the Fed’s first cut—and in the subsequent months afterward, as the easing cycle matured.
All else being equal, bond math tells us it’s more beneficial to have exposure to intermediate- and longer-duration assets than to shorter duration assets when interest rates fall. Duration, or interest-rate risk, is a way of gauging how sensitive a fixed-income investment is to a change in interest rates. Bond prices and interest rates move inversely; for every 1% shift in interest rates, a bond’s price will change in the opposite direction by roughly 1% for every year of duration embedded in the bond. In a falling interest-rate environment, the price of an intermediate-term bond with a duration of five years, for example, would rise more than that of a shorter-term bond with a duration of two years.
The bottom line: Historically, the higher duration profile of intermediate-term bonds, compared with shorter-term bonds, has been a relative advantage in the months following the Fed’s first interest-rate cut of the cycle.
Bond market history lesson 2: quality has gone the distance
To develop our analysis further, we looked beyond the interest-rate risk factor and studied the behavior of bond segments with varying levels of credit risk by looking at the average total returns for the year following the Fed’s first rate cut in each of the last two easing cycles.
We graphed the performance of five different bond asset classes in the 12 months following the first Fed rate cut, an average of the last two easing cycles, in 2001 and in 2007. Notably, credit-sensitive segments—particularly U.S. high yield and emerging-market debt—performed well in the initial weeks and months following the first rate cut. However, their performance began to fade deeper into the easing cycle, as leadership transitioned to higher-quality core bond segments, such as U.S. investment-grade corporates, mortgage-backed securities, and U.S. government bonds.
The bottom line: The advantage of credit-sensitive segments following the first Fed rate cut has been short-lived in the last two easing cycles; higher-quality core fixed-income asset classes have demonstrated a more enduring relative edge.
What to do now
We might see a further fall in intermediate-term yields now that the Fed has proven its willingness to cut interest rates, its first such demonstration in over a decade. While more aggressive fixed-income asset classes may respond positively at the outset, they have a history of suffering from price volatility as the cycle matures. As investors consider the relative attractiveness of various fixed-income strategies at this point in the cycle, we remain favorable toward the intermediate-term part of the curve—exposure best implemented with high-quality core bond strategies, in our view.