By Randall W. Forsyth
The "cash is trash" talk is back. What's different is that money-market rates were near zero when that phrase was last heard. But it's being reprised now that the Federal Reserve has begun bringing down its key policy interest rate from over 5%, the highest in over a decade and a half.
With the Fed projecting further rate reductions to around 3.4% by the end of 2025, from the current target range of 4.75% to 5%, and financial-futures market pricing in even steeper cuts, the clarion call of financial advisors is to get out of money-market funds, certificates of deposit, and Treasury bills before it's too late.
Well, it may be already too late. The bond market has already priced in anticipation of sharp Fed rate reductions -- perhaps too much so. A five-year Treasury note yield of 3.77%, well below the 4.60% from the Fidelity Government Money Market fund, effectively prices in rate cuts priced in the fed funds futures market.
To say futures market forecasts have been subject to change is an understatement. Since the beginning of 2024, traders' expectations have lurched from six or seven quarter-point cuts by year-end to none. Now, after last month's supersize half-point cut, fed-funds futures were pricing in, as of Thursday's settlement, a total of three-quarters of a point by December, to a range of 4% to 4.25%, according to the CME FedWatch site. Even after a sharp reassessment following Friday's strong jobs report, that's still more aggressive than the Federal Open Market Committee's latest Summary of Economic Projections, which has a median single-point year-end rate of 4.4%, implying just two quarter-point cuts from here.
All of which suggests that the advice to flee cash equivalents may be ill-timed, either because bond yields have already fallen ahead of Fed rate cuts or because yields may rebound from here. No less an investor than Warren Buffett was still building Berkshire Hathaway's hoard of Treasury bills to $277 billion at the end of the second quarter, then equal to 88% of the conglomerate's equity portfolio, Grant's Interest Rate Observer wrote in September. The Oracle of Omaha evidently would rather see Berkshire's interest income decline than risk potential losses from longer maturities. And Berkshire continued to pare its equity holdings, most recently offloading more of its Bank of America stock.
The public is also sitting on nearly $6.5 trillion in money-market fund assets, a record, despite anticipating lower rates ahead.
According to the University of Michigan's latest consumer expectations survey, some 55% of respondents expect rates to decline in the next year. "In the last half century, 'civilians' have never been this bullish on the bond market," observed James Bianco, who heads Bianco Research, this past week. (Bond prices, of course, rise when rates decline.) "Contrarians, what direction do you think rates will go?" he asked. Among these contrarians is legendary investor Stanley Druckenmiller, who told Grant's Fall Conference this past week that he was shorting long bonds.
Unless the U.S. economy enters a recession, don't look for short-to-intermediate Treasury yields to fall relative to those of longer-dated bonds, according to the latest U.S. bond strategy from BCA Research. Moreover, the advisory argues that investment-grade and high-yield corporate bonds didn't provide sufficient extra yield to compensate for their credit risk.
Mortgage-backed securities should fare better in a likely economic soft landing, which BCA said would feature flat-to-higher yields. The most feasible way to invest in the sector is through funds, such as the iShares MBS (ticker: MBB), Vanguard Mortgage-Backed Securities $(VMBS)$ and the Simplify MBS $(MTBA)$ exchange-traded funds.
While money-market funds will see their returns reduced by Fed rate cuts, closed-end funds should benefit. Unlike more familiar mutual funds and ETFs, CEFs issue a set number of shares, which trade on exchanges, above or (more often) below their net asset values. Most CEFs also utilize leverage -- they borrow, frequently at costs linked to short-term market rates. Fed rate cuts should trim their financing costs while boosting the value of their investment portfolios.
Markets anticipated the Fed's moves and have bid up many CEFs, says Sangeeta Marfatia, senior closed-end fund strategist at UBS. Many CEFs also locked in borrowing costs with interest-rate swaps. Fewer CEFs are trading cheaply with a narrowing of discounts, she adds.
That said, Marfatia has buy ratings on two corporate cousins, Cohen & Steers REIT & Preferred & Income $(RNP)$ and Cohen & Steers Quality Income Realty $(RQI)$. The former is split evenly between fixed-income and equity securities while the latter has an 80% weighting in REIT equities.
Discounts have narrowed across the board, concurs David Tepper, the eponym of Tepper Capital Management, a San Francisco-based advisory firm (and no relation to the similarly named NFL team owner and hedge-fund manager). Still attractively priced is Gabelli Dividend & Income Trust $(GDV)$ at nearly a 14% discount while yielding 5.4% from a portfolio of large capitalization blue chips. He also likes Royce Global Trust $(RGT)$ at a 12% discount from its portfolio of global small-caps; its dividend is a relatively low 1.29%.
Municipal bonds, a perennial favorite of closed-end investors, also have been bid up. Marfatia notes some have lifted their distributions beyond what they are earning, resulting in a return of capital. She would stick with unleveraged municipal CEFs. The biggest example is Nuveen Municipal Value $(NUV)$, with a 4.7% discount and a 4.1% federally tax-free yield.
Tepper likes Pimco California Municipal Income Fund II $(PCK)$ and Pimco New York Municipal Income Fund II $(PNI)$. Unlike many Pimco taxable-bond CEFs that command premiums, these muni funds trade at discounts of over 9% and yield more than 4%.
These leveraged funds should benefit as their cost of borrowings decline. That's unlike most fixed-income investments, which already have been bid up and may suffer if rates fail to meet traders' expectations of Fed cuts.
Write to Randall W. Forsyth at randall.forsyth@barrons.com
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
October 04, 2024 11:35 ET (15:35 GMT)
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