Fixed income: funds for capitalizing on the upcoming rate cuts

Financial markets are expectant about future rate cuts by central banks. Every analyst is trying to discern when the interest rate cuts will be approved, as the schedule that was initially projected has changed.

The stronger U.S. economy and stickier-than-expected inflation have delayed expectations of monetary policy easing by the U.S. Federal Reserve (the Fed). On this side of the Atlantic, the greater weakness of the European economy suggests that the European Central Bank (ECB) is likely to approve an initial interest rate cut at its June meeting, ahead of its U.S. counterpart.

What’s the best investment move to make in a scenario such as the present one? Fixed income markets are directly affected by monetary policy decisions. “Market interest rates and bond prices generally move in opposite directions. Profitability, in any event, is moving in the same direction as rates. In short, when rates go up, fixed-rate bond prices go down and yields go up, and vice versa,” explained Juan Nozal, MAPFRE AM Manager, in this recent article.

Interest rate cuts are usually accompanied by a rise in bond prices. "When interest rates decline, newly issued bonds offer lower interest rates compared to older ones, causing the price of the latter to typically rise above their original face value in the secondary market (while coupon payments remain unaffected)," Nozal pointed out.

If the ECB meets expectations and delivers the expected rate cut in June, it will be creating a favorable environment for bonds with longer durations. Hence, extending duration in the fixed income portfolio can be an attractive strategy to capitalize on rising bond prices.

“Shorter-term yields are directly affected by monetary policy, i.e., central bank decisions on interest rates. However, longer-term maturities better reflect investors' expectations about the direction of inflation, growth, and interest rates in the medium and long term," Nozal said.

This is a scenario that also carries risks: if interest rates rise rather than fall, the prices of bonds with longer durations could fall significantly. Therefore, it's important to approach this strategy with caution and in alignment with the economic and monetary policy expectations set by the European banking supervisor.

“All indications suggest that central banks will start lowering interest rates in the upcoming months due to the relatively controlled or stabilizing downward trend in inflation, which will contribute to creating a more positive interest rate curve. The ideal timing for increasing duration should coincide with a steeper slope in the curve. That is, a higher return in the long term than in the short term that would justify the higher duration risk,” said the Fixed Income Manager at MAPFRE AM.

As always, if you're uncertain about how to navigate economic cycles and volatility, and how to "surf" the market without risking drowning, turning to active management and/or consulting a financial expert can be extremely helpful.

How to extend portfolio duration

Spaniards tend to have a conservative mindset when it comes to investing their savings, preferring to avoid taking on too much risk with their money. As a result, many individuals have invested in fixed income maturity funds with a target return during 2023 and the first few months of 2024.

Now, it might be more suitable for this type of investor to extend the duration of their fixed income portfolios. In other words, instead of a short-term fixed income fund, opt for a fixed income fund without a fixed term. This allows managers to choose the right bonds to take advantage of any given market moment.

This is the case of the Fondmapfre Renta Fija Flexible mutual fund, which was formerly called Fondmapfre Renta Largo. This product invests in public and private fixed income assets, mainly in OECD countries. The main positions in the portfolio are occupied by Belgian, Spanish, and French government bonds.

This product is designed for investors with a longer investment horizon. “It may not be suitable for investors who expect to withdraw their money in less than five years,” the fund manager noted. Currently, this investment vehicle manages assets worth 89.8 million euros, according to the latest data available from Morningstar.

Another option that also takes such a long-term view is the MAPFRE AM Global Bond Fund. This product is a global fixed income fund that actively invests in debt instruments with a minimum investment grade credit rating. Currently, German and Australian debt issues occupy the largest positions in the portfolio. This investment vehicle has 223 million euros in assets under management.

In addition to these two MAPFRE AM products, Ismael García Puente, Head of Investments and Fund Selector at MAPFRE Gestión Patrimonial, highlights three investment vehicles from renowned international fund managers that also focus on long-term fixed income. These are the mutual funds Flossbach von Storch Bond Opportunities, Fidelity US Dollar Bond, and Franklin European Total Return.