Where to Find Returns When Interest Rates Fall

With inflation on the downtrend and cash rates expected to fall around the globe, how should investors position the fixed-income portion of their portfolios?

We explore how investors can position their US Treasury, corporate bond, and non-US bond exposures in a falling interest-rate environment.

A Look at Federal-Funds Rate Forecasts

The Federal Reserve initiated interest-rate cuts in September 2024 after having kept the federal-funds rate at an elevated l5.25%–5.50% level since July 2023 to combat high inflation—a battle that appears mostly won.

Entering this new phase in the monetary policy cycle, our economics team expects this rate to fall to the 4.25%–4.50% range by the end of 2024, 3.00%–3.25% by the end of 2025, and 2.00%–2.25% by the end of 2026, substantially reducing the income that bank deposits can generate.

Federal-Funds Rate Forecasts, Year End (Bottom of Target Range)

US Investors Are Still Holding Onto Cash

While cash deposits have many uses inside a portfolio, we continue to see elevated cash levels “on the sidelines” rather than making a useful contribution to returns. For a long-term investor, holding too much cash has historically led to lower long-term portfolio returns compared with nearly all other fixed-income asset classes.

According to the Investment Company Institute, money market (cash) fund assets rose to $6.51 trillion as of Oct. 23, 2024. A further look at net monthly US money market fund flows highlights that investors have not unwound large cash hoards after the height of the covid pandemic.

US Treasuries: Consider Longer-Term Bonds as Interest Rates Drop

Should our fed-funds rate forecasts play out, investors would benefit by holding longer-term fixed-income bonds to maintain higher income levels. For example, the 10-year Treasury yield stands at 4.3%. If we assume a 1% term spread (the difference between shorter- and longer-term bond yields to account for the risk of longer-term investments), that implies an expected average fed-funds rate of 3.3% over the next 10 years. By contrast, we expect the fed-funds rate to average 2.3% over the next 10 years. Consequently, longer-term government bonds appear to offer an attractive total return opportunity relative to cash deposits.

The benefits of holding cash fade in a world with falling global yields. By definition, cash cannot offer any price appreciation when rates decline, unlike longer-term bonds. This leaves income as the only return contributor for cash—a factor that will decline as the Fed continues to lower rates.

Now is a good time to move from cash to longer-dated exposures. As the chart above shows, extending from cash now requires giving up less yield than at any point since 2022. The yield advantage dissipates quickly as easing cycles begin, so moving quickly has been rewarded. The intermediate segment of the yield curve (bonds with a five- to seven-year life) offers an attractive risk/reward balance as there is the opportunity for price appreciation without the larger drawdown risk that 30-year bonds carry if rates were to unexpectedly increase.

Corporate Bonds: The Risk May Not Be Worth the Reward

In contrast to government bonds, corporate debt offers unusually low returns for the additional credit risk that an investor must accept. While this may not come as news, a historical perspective reveals just how extreme current valuation levels have become. We can use credit spreads (technically the option-adjusted spread), which measure the additional yield that investors receive to take on credit risk, as a proxy for valuations. The tighter the spreads, the more costly credit assets are.

Currently, US investment-grade corporate bond spreads are at their 16th percentile tightest level, last seen in 2021. During that period, the Fed’s unprecedented intervention in the corporate-bond market supported the economy’s recovery from the covid shock, with investment-grade spreads troughing at 81 basis points. Before that, spreads were last this tight in 2005—almost 20 years ago.

For US high-yield bonds, the situation is even more pronounced. The current spread of 282 basis points places them at the sixth percentile tightest level in history.

This trend is not confined to the US; global corporate-bond spreads are also compressed, sitting at the 18th percentile. While not as extreme as in the US, it’s clear that valuations are far from cheap.

One might argue that, in a soft-landing scenario, tight spreads could persist, allowing investors to benefit from higher all-in yields. However, historical precedent offers a cautionary perspective.

We examined the past six easing cycles since 1995, two of which did not coincide with a recession. In these two cases, credit spreads held steady in the 12 months following the first rate cut. However, the average starting spread level was notably higher than it is in the current cycle.

This points to an asymmetric risk profile for credit assets: limited upside owing to historically tight spreads, coupled with significant downside risk should the economy experience a hard landing.

Global Bonds: Emerging Markets Offer Attractive Real Yields

Outside of the US, we see some opportunities to add diversification and attractive yields to portfolios via global sovereign bonds.

A simple rule of thumb when investing across the global-bond universe is to focus on real yields. In other words, look where nominal yields are higher than prevailing inflation and central bank inflation targets.

Under this framework, we see significant divergence across economies and countries. There are some very attractive real yields available in the emerging-markets space, including Brazil, whose five-year bond yield of 14.1% looks compelling against an inflation rate of 4.8%, and Mexico, which is issuing five-year debt with a yield of 10.1% against the Consumer Price Index of 4.8%.

Alternatively, in Europe and Japan, bond yields are not offering investors much headroom above inflation. In fact, in Japan, real yields are negative, and there is a reasonable probability of further interest-rate hikes in 2025 if this persists.

This article includes contributions from:

• Hong Cheng, Head of Fixed Income and Currency Research
• Mark Preskett, Senior Portfolio Manager
• Paul Arnold, Global Head of Multi-Asset Research