How Investors Should Think About Bonds In A Rate-Cutting Environment

Co-authored by Victory Income Investors

Fixed income and equities have long been the foundation of a well-rounded investment portfolio. But fixed income’s reputation has been bruised in recent years due to the combination of historically low interest rates (which hurt bond yields), followed by an aggressive cycle of interest rate hikes (which hammered bond prices). Some investors began questioning the validity of the traditional 60/40 portfolio comprised of 60% equities and 40% fixed income.

Such pronouncements are short-sighted and ignore the long-term diversification and income benefits of bonds. Meanwhile, the upcoming cycle of interest rate cuts provides potential opportunities for fixed-income investors. We spoke with Jim Jackson, co-chief investment officer and senior portfolio manager of Victory Income Investors, about how investors can navigate this terrain. Jackson and his team manage a wide array of taxable and tax-exempt fixed-income strategies.

Q: Bonds are generally thought to be reliable and predictable. Why hasn’t that been the case of late?

Jackson: What a ride the bond market has been on over the past several years. During the Federal Reserve’s historic rate-hike campaign in 2022, many fixed-income investors were worried that bonds had lost their mojo. Elevated volatility was (and still might be) the new norm, and prices were under pressure as yields climbed rapidly from extremely low levels. However, bonds found their footing as rate hikes moderated and the Fed finally paused in 2023. And late last year fixed-income markets rallied sharply as it appeared we had reached the terminal rate, or the peak in this rate-hike cycle.

Q: So, what’s next for bonds?

Jackson: Recent robust employment data and comments from Federal Reserve Chairman Powell mean that it’s less likely the Fed will begin cutting rates imminently. That decision will be swayed by upcoming GDP, labor market and inflation data, which is often surprising. That’s why we don’t make interest rate bets when crafting portfolios. 

Q: What can bond investors expect in a rate-cutting environment?

Jackson: Based on our analysis, historically, the end of Fed rate-hiking cycles have presented attractive opportunities for fixed income. And more specifically, we have seen intermediate-duration asset classes outperform their shorter-duration counterparts during these times.

Past performance is no guarantee of future results. Indexes are unmanaged and do not reflect fees and expenses; One cannot invest directly in an index.

For the chart above/below our team analyzed the past rate hiking cycles from 1995-2018 and calculated the average annualized returns for the 1 and 3-year periods following a pause in Fed rate hikes. Figures displayed represent the average annualized returns over the past 4 rate hiking cycles. “Pause” is defined as the period between the last rate hike and the first rate cut.

Q: How should investors implement their fixed-income strategy?

Jackson: While passive investment strategies have become popular, we think passive approaches might have more embedded risk than many investors realize.

For instance, the duration (a measure of interest rate sensitivity) of the Bloomberg US Aggregate Bond Index increased prior to the most recent rate-hike cycle. Many investors didn’t realize that bond funds following this passive index were adding duration at the exact wrong time.

Instead, we think tilting a portfolio toward their preferred asset type, sector or duration profile can be a potential risk-mitigation feature. For example, based on the current economic backdrop we continue to remain defensive with regard to credit risk across strategies due to lingering recessionary headwinds.

In general, we see better potential in asset-backed securities (ABS) and agency mortgage-backed securities (MBS) relative to other fixed-income asset classes. Meanwhile, corporate investment-grade and high-yield sectors look expensive and generally don’t offer sufficient compensation for credit risk.

As recent history has shown, the bond market offers ample opportunity, but not without risk or volatility. We think the ability to shift between sectors and bond types is not only a key risk-management tool, but also a path to potentially capturing incremental yield. Thus, we prefer an active approach, especially in this environment.

The fixed-income team at Victory manages more than $30 billion across taxable, tax-exempt and money market mutual funds and institutional strategies. Additionally, the fundamental, bottom-up security selection process they employ underpins four actively managed fixed-income ETFs listed on Nasdaq: VictoryShares Core Intermediate Bond ETF (UITB); VictoryShares Short-Term Bond ETF (USTB); VictoryShares Core Plus Intermediate Bond ETF (UBND); and VictoryShares Corporate Bond ETF (UCRD).

For more information on Victory Income Investors and their suite of active fixed income solutions, visit www.vcm.com.

Nasdaq® is a registered trademark of Nasdaq, Inc. The information contained above is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security, digital asset or an overall investment strategy. Neither Nasdaq, Inc. nor any of its affiliates makes any recommendation to buy or sell any security or digital asset or any representation about the financial condition of any company. Statements regarding Nasdaq-listed companies or Nasdaq proprietary indexes are not guarantees of future performance. Actual results may differ materially from those expressed or implied. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. 

ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED. 

© 2024. Nasdaq, Inc. All Rights Reserved. 

Carefully consider a fund's investment objectives, risks, charges and expenses before investing. To obtain a prospectus or summary prospectus containing this and other important information, visit vcm.com/prospectus. Read it carefully before investing.

All investing involves risk, including the potential loss of principal. In addition to the normal risks associated with investing, fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. Bonds and bond funds will decrease in value as interest rates rise and vice versa. Credit risk refers to the possibility that debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price than higher-rated securities of similar maturity. Mortgage-backed securities (“MBS”) and asset-backed securities ("ABS") are subject to credit, prepayment and extension risk and may react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly and significantly reduce the value of certain MBS and ABS.

Large shareholders, including other funds advised by the Adviser, may own a substantial amount of the ETFs’ shares. The actions of large shareholders, including large inflows or outflows, may adversely affect other shareholders, including potentially increasing capital gains. Redemptions are limited, and commissions are often charged on each trade. ETFs may trade at a premium or discount to their net asset value. The ETFs have the same risks as the underlying securities traded on the exchange throughout the day.

The ETFs are also subject to liquidity risk, which is the risk that the Adviser may not be able to sell a security at an advantageous time or price, which may adversely affect the Fund. The value of your investment is also subject to geopolitical risks such as wars, terrorism, environmental disasters, and public health crises; the risk of technology malfunctions or disruptions; and the responses to such events by governments and/or individual companies.

The Bloomberg U.S. Treasury Bills 1-3 Month Index is designed to measure the performance of public obligations of the U.S. Treasury that have a remaining maturity of greater than or equal to 1 month and less than 3 months.

The Bloomberg U.S. Aggregate 1-3 Year Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury with maturities ranging from 1 to less than 3 years.

The Bloomberg U.S. Aggregate Bond Index (Bloomberg US Aggregate) measures the investment grade, USD-denominated, fixed rate taxable bond market. The index includes Treasurys, government related and corporate securities, MBS, ABS and CMBS.

Distributed by Foreside Fund Services, LLC (Foreside). Foreside is not affiliated with Victory Capital Management Inc., the Fund's advisor.

20240416-3490533