Where can bond investors find value in a rate-cutting cycle?

The US Federal Reserve (the Fed) is attempting to balance ongoing inflation risks amid a weakening US jobs market and has begun cautiously easing monetary policy. In such uncertain conditions, we believe that short duration bonds look particularly attractive.

The Federal Open Markets Committee (FOMC) cut rates for the first time this year in September, lowering its target range for the federal funds rate by 25 basis points to 4%-4.25%. The latest forecasts suggest the market expects two more cuts this year, followed by two or more in 2026.

Locking in

The outlook for the US economy remains fraught amid ongoing global trade tensions, stubbornly persistent inflation – which rose to 2.9% in August – and a sharp drop in the number of job openings (the US added just 22,000 jobs in August, while unemployment stands at 4.3%, the highest level in four years). As a result, yields on longer maturity debt remain elevated.

It is a backdrop that bolsters the argument for short-duration debt, allowing investors to lock in higher returns at the present time, while reducing exposure to longer-term risk. If the rate-cutting cycle unfolds as anticipated, investors can secure these elevated yields. In the event that rates fall faster than expected, we believe investors in this space still stand to benefit from capital appreciation.

Why move up the curve from cash?

Short-duration debt – typically between one and three years – offers the ability to access benefits such as lower exposure to interest rate risk, while at the same time taking the opportunity to take a step up the yield curve from cash to potentially secure higher yields.

While subject to great volatility, short-duration bonds have the potential for capital appreciation in the event that bond prices rise. In a rate-cutting environment, bond yields typically fall while prices move inversely.

Why not keep moving up the curve?

Longer-dated credit is more sensitive to both interest rate risk and credit risk. So while these bonds typically offer investors higher yields, any compensation expectations have to be balanced with more credit risk or spread duration. Sovereign debt yields at the back end of the curve, for example, have remained elevated this year amid growing concerns about the state of developed government finances and their mounting debt burdens.

The case for short duration

The Fed’s resumption of its rate-cutting cycle presents investors with an attractive window to allocate to short duration bonds: an opportunity to lock in historically elevated yields, and potential capital appreciation, while at the same time mitigating some of the myriad risks in an uncertain global economic environment.