- LPL says to consider shifting from cash to medium-term bonds as the Fed plans rate cuts.
- Options for medium-term bonds: ETFs, separately managed accounts, and bond ladders.
- Medium-term bonds also offer protection in a recession.
The past year and a half has been the best period in more than 20 years to be sitting in cash. But the times of free money may soon be coming to an end.
As the Federal Reserve has jacked up interest rates to curb inflation, investors have been able to collect a robust coupon of over 5% in certificates of deposit, money-market accounts, and short-end bonds. Now, as the central bank seems ready to cut interest rates, it may be time to move out of these short-term instruments, said Lawrence Gillum, the chief fixed income strategist for LPL Financial, which oversees $1.35 trillion.
Instead, with rates still high for the time being, investors looking to lock in solid returns might want to start thinking about moving into more medium-term bonds while they still can, Gillum said in a recent client note.
"We know those attractive cash rates aren't going to last forever. Just as the aggressive rate hiking cycle took Treasury yields higher, interest rate cuts will eventually take all cash rates lower as well," Gillum said. "Locking into high-quality, intermediate-term fixed income can provide consistent cash flow and desirable income levels for years to come, regardless of what lies around the corner."
Gillum listed three ways in which investors can gain exposure to medium-term bonds. The first is through exchange-traded funds that are specifically structured to follow the Bloomberg Aggregate Index. Some examples include the iShares Core US Aggregate Bond ETF (AGG), the BNY Mellon Core Bond ETF (BKAG), and the Schwab US Aggregate Bond ETF (SCHZ).
The second way is through separately managed accounts, or SMAs, which are personalized investment portfolios actively managed by professionals for a fee. Investment banks, brokerages, and asset management firms offer them.
And third, investors can build a bond ladder, meaning they stagger their money in different bond durations. For example, if an investor had $40,000, they could put $10,000 each in the three-, five-, seven-, and 10-year Treasurys. This strategy allows investors a higher degree of liquidity than, say, putting all of their money into a 10-year bond, as some of their funds get freed up every two or three years. They can then decide how to best reinvest that money based on market conditions at the time.
Ensuring future returns is one reason to start stepping into more intermediate durations, Gillum said there's also the added benefit of cashing in if the economy goes south. During economic downturns, medium- and long-end bond yields typically fall as investors seek safety. Higher demand for the assets pushes up their prices, which brings down their yield.
If this were to happen, investors who bought at current levels would likely be able to sell their bonds for a nice profit, Gillum said.
"Bonds offer an optionality that you don't get from cash. Although bonds and cash currently offer similar yields, bonds provide extra portfolio protection and the chance for price increases if the economy faces unexpected challenges, which cash does not offer," he said. "Additionally, over the past 40 years (ending April 2024), bonds have averaged a 6.1% annual return versus about 3.5% for cash."
There's still uncertainty about when the Fed will actually begin to cut rates. In December, investors expected the first rate cut to come at the FOMC's March 2024 meeting. But jobs and inflation data have remained hot, forcing the central bank to leave rates elevated. The CME's FedWatch Tool now places the highest odds on September for the Fed's first rate cut.
April job openings fell more than expected, and the unemployment rate, though still historically low, has continued to trend upward, perhaps signaling that the labor market is softening enough for the Fed to cut rates. But inflation is still above 3%, and a reacceleration in consumer price growth could push rate cuts out further.
