Navigating the New Fixed Income Regime: Trends and Strategies

It’s hard to fight trends. Even the best-laid plans can be side-swiped by the market and the turn of the tide. That’s why it makes sense to follow trends with our portfolios. And in the world of fixed income, several major new trends are starting to emerge with the Federal Reserve’s path to tightening.

There are three of them in fact, according to investment manager T. Rowe Price.

These three trends are creating a new fixed income regime that has the potential to last quite a while and shift both short- and long-term expectations. For investors looking at adding bonds to their portfolios, the asset manager’s latest missive could be worth following.

The New Fixed Income Regime

We all know and understand what has happened. After the post-COVID-19 economic reopening, stimulus packages, supply/demand imbalances and supply chain woes, inflation and the economy got out of hand. To that end, the Federal Reserve (the Fed) began its current path of monetary tightening. Since March of 2022, the central bank has hiked rates 11 times in 17 months to bring borrowing up to 5.3% – the highest rate since 2001.

The question is what will the Fed do next?

At the Fed’s Jackson Hole retreat, Chair Powell indicated that policymakers may not raise rates again at their next meeting in September. And there is certainly cause to pause. Overall, inflation has been trending lower, while economic data has been declining. There’s plenty of potential for the Fed’s path of rate hikes to wind down sooner than later. Even the chance for a Fed pivot towards rate cuts is on the table.

According to asset manager T. Rowe Price, this is the beginning of a new fixed income regime. The transition from quantitative tightening to a pause and then to quantitative easing sets forth a new era for fixed income investors. To that end, there are several trends investors need to be aware of that are starting to form.

Trend 1: Rising Volatility

Transitions are never easy. So, the switch from raising rates to cutting them won’t be easy either. T. Rowe Price expects that volatility in the fixed income world will increase as the new regime takes hold. This is particularly true when it comes to short-term bonds and cash. As the yield curve reverts back to normal, those seeking shelter in T-bills could experience volatility. At the same time, those looking further out may experience quick surges in pricing, limiting the ability to score bonds at good prices and yields.

Trend 2: Higher Interest Rates for Longer Period & New Credit Risks

Investors may be in for a shock when it comes to interest rates and the general level at which they stay high. The severity of the great Recession and COVID-19 pandemic required the Fed to take drastic action, which meant cutting rates to zero. And they stayed there for the better part of a decade.

However, with borrowing costs already so high, T. Rowe Price estimates that even if a recession happens and the Fed is forced to pause/pivot, interest rates will most likely never get down to that zero level again. From 1970 to 2023, interest rates for the United States averaged about 5.42%. Going back further to 1817, the average rate was 3.81%.

This adds plenty of additional credit risk to the system that investors may not be thinking of. Corporate bonds, junk bonds and even the U.S. Treasuries will be forced to deal with higher borrowing costs in the next decade than during the previous one. That could be a problem for many firms. The same could be said for foreign nations, which are also now dealing with rate hikes and higher interest rates of their own.

Trend 3: Stock/Bond Correlations Set to Return

For investors, there’s this idea that stocks and bonds move in opposite directions. Fixed income assets serve as a hedge for equities based on this opposite movement. But that isn’t necessarily the case and one that has been a roughly new phenomenon, starting during the Dot-com Bust. In fact, bonds and stocks are often positively correlated and have been like that for most of modern history.

Lately, they have been moving opposite of each other due to the rise in interest rates and recessionary expectations. However, according to T. Rowe. Price, the shift in lower inflation will once again cause the correlations to be positive. For investors using fixed income as a direct hedge, this may not be in their favor.

Playing the New Fixed Income Regime

Given the switch and the shifting trends, investors need to prepare themselves before these changes occur. T. Rowe Price lays out the case that being proactive is better than being reactive.

For rising shortterm volatility, the asset manager suggests looking at the complete curve and using duration management. This means investors may want to reduce holdings of short-term bonds and cash, while buying those further out on the ladder. The Invesco 1-30 Laddered Treasury ETF actually does this and holds bonds across the spectrum. However, investors may want to do it over time, moving assets from a vehicle like the SPDR Bloomberg 1-3 Month T-Bill ETF to the iShares 7-10 Year Treasury Bond ETF and so forth.

For higher-for-longer and rising credit risks, investors may want to focus on bonds with high credit quality. Junk and other high-yield sectors may have issues repaying their bonds. Even in corporate debt, that might mean moving up the credit ladder. The iShares Aaa – A Rated Corporate Bond ETF allows investors to bet on the top tier of investment-grade corporate bonds, for example.

Finally, with correlations starting to become positive once again, T. Rowe Price suggests that duration management and other hedges be used to find a portfolio buoy. The asset manager suggests that currency or derivatives take center stage as portfolio ballast. A non-correlated ETF like the Invesco DB US Dollar Index Bullish Fund or iShares S&P GSCI Commodity-Indexed Trust could also be considered for hedging purposes, going forward.

ETFs for the New Fixed Income Regime

The Bottom Line

The shift in interest rates and the potential pivot is expected to cause plenty of widespread issues within the bond sector. According to asset manager T. Rowe Price, this will kick start a new bond regime. For fixed income investors, playing this new regime could be the key to success over the next few years.