Portfolio perspectives

Reinvestment risk for cash is here: Considerations for advisors

Many of our financial advisor clients have been asking this question for much of the last 12 months: “Is it time to extend duration on cash?” Recently, as we neared the start of the Fed’s cutting cycle, the tenor of our conversations has changed to: “Have I missed the opportunity to extend duration?” While that question will always be specific to the needs of your clients and practice, allow us to provide some guidance:

• What changed? On September 18, the Federal Reserve voted to decrease rates by 50 basis points, kicking off a new cutting cycle. Since the end of the second quarter, the market has been expecting and starting to price in multiple cuts this year into next year, with the two-year Treasury falling by approximately 70 basis points (BPS). Additionally, the Fed dot plots and expectations from Vanguard suggest rate cuts through 2024 into 2025. While it’s difficult to know exactly how the yield curve will evolve in the coming months, we have conviction that short-term rates for cash will be resetting lower, bringing reinvestment risk to the forefront.

• Bond yields are higher now than for most of the last two decades. In fact, the Bloomberg Barclay’s Aggregate Index is at 4.64% as of October 24, which places it in the 77th percentile more than the last two decades. This is important for three reasons: The future return expectations are higher for the asset class than most periods in recent history. Secondly, even if rates do back up modestly from here, the income cushion provides protection with higher income streams.  Lastly, bonds can provide strong diversification to a client’s stock holdings if the economy does cool in 2025 and the market needs to price in even more Fed rate cuts.  
  

• Bonds frequently outperform cash, especially after the first rate cut. Vanguard’s Investment Advisory Research Center analyzed the last 17 Fed rate-cutting cycles and the relationship between cash and bond performance at both peak rates and once the Fed commences its cutting cycle. Figure 1 below shows the 5-year Treasury performance over cash (net return).  In 16 of the last 17 cycles, the five-year portion of the curve has outperformed.  Additionally, in six of the last seven cycles, the outperformance has been quite meaningful, and a significant majority came after the first cut (tan bar).

Next steps for consideration: Become familiar with Fed rate-cutting cycles

Check out this Vanguard video on the Fed’s new rate-cutting cycle. In addition, if you would like to get a custom analysis of your portfolio or to speak to a specialist about our rate-cutting cycle research (Challenges for advisors assessing historical peak rate cycles), reach out to Vanguard Portfolio Solutions.

Navigating the future of floating-rate bonds

As we move into a new Fed rate-cutting cycle, the role of floating-rate bonds in investment portfolios may need to be re-evaluated. Many floating-rate bond strategies, which performed well during the period of rising interest rates and credit-spread tightening, may now face challenges as their adjustable coupon payments get reinvested at lower rates. Investors might want to consider fixed coupon strategies to lock in more durable yields as the market conditions have changed.

The types of floating-rate bonds commonly found in advisor portfolios include:

• Corporate floating-rate bonds.
• Leveraged loans, often packaged into collateralized loan obligations (CLOs).
• Floating-rate tranches of asset-backed securities (ABS).
• U.S. Treasury floating-rate notes.

Each of these instruments has recently played a role in capturing yield while protecting against rising rates.

Trending product spotlight: Recent popularity of CLO ETFs

The CLO asset class has grown to more than $1 trillion (source: Bloomberg, as of June 29, 2024), and retail-focused products (particularly AAA-rated CLO ETFs) have benefitted from broader investor access in what once was an institutional-only asset class.

CLOs are special-purpose vehicles set up to invest in, hold, and manage pools for leveraged loans. Although the underlying bank loans that back CLO pools are sensitive to economic stress, the CLO structure (especially AAA tranches) provides credit enhancement protections, resulting in higher credit ratings from rating agencies.

Recent performance has many advisors examining the use case for these strategies as outright replacements to traditional ultrashort bond funds. CLOs are floating-rate instruments, so the asset class has benefited from both the rate hiking cycle and the benign credit backdrop over the last few years. However, CLOs can and do react to changes in credit risk expectations. The 2020 COVID-induced credit selloff is a great example of this. To illustrate, we can measure the peak-to-trough total return drawdown of both higher- and lower-quality segments of the CLO market (see Figure 2). The volatility of the underlying low-credit quality collateral begins to clearly show up as you remove layers of CLO structural protections.

Clients primarily look for ultrashort bond sleeves to provide a combination of safety and liquidity, especially during times of economic stress. Even broadly diversified senior tranches of CLOs can exhibit deep drawdowns, which, in our view, should negate the impulse of replacing your traditional ultrashort products.

As we look ahead, the environment for all types of floating rate bonds has changed. Given recent rate cuts, with more expected on the horizon, the floating rate characteristics that helped these instruments perform well will now work against them.  Moreover, spreads have tightened, and, in a scenario where growth slows and investor concerns grow, credit spreads have room to widen, particularly in lower quality. Widening credit spreads would result in a decline in bond prices, especially for those instruments with higher credit risk. This would further diminish the appeal of credit-sensitive floating-rate bonds in a portfolio, as investors would face both declining income and potential capital losses.

Outside of broad and global diversification, there is no free lunch in investing. Managing tradeoffs is of the utmost importance in portfolio construction, and CLOs aren’t risk free, either.

Next steps to consider: Re-examine the appeal of floating-rate bonds

Floating-rate bonds have performed well and attracted advisors to use them as an alternative to money markets and ultrashort bond funds. These strategies may be at risk to falling rates and potential credit-spread widening, suggesting their role in portfolios may need to be adjusted. If rates were to fall further, and your clients still have a short-duration bias, you might consider one- to three-year fixed coupon bonds. This approach could help investors navigate the challenges ahead, maintaining income and potentially benefiting from a bond price appreciation. Here are some Vanguard products to consider:

• Taxable index: Short-Term Treasury ETF (VGSH),
  Short-Term Corporate Bond ETF (VCSH).
• Taxable active: Ultra-Short Bond ETF (VUSB), Short-Term Investment-Grade Fund Admiral Shares (VFSUX).
• Tax-exempt index: Short-Term Tax-Exempt Bond ETF (VTES).
• Tax-exempt active: Limited-Term Tax-Exempt Fund Admiral Shares (VMLUX).