What rate cuts mean for fixed income

The Federal Reserve has been cutting interest rates in response to concerns over slowing job growth and an uptick in unemployment. Normally, that would push investors away from riskier assets and towards assets perceived to be safer, such as Treasuries. However, this rate-cutting cycle has a different tone, experts said.

“This time, we’re not talking about a recession. Growth is still positive,” said BOK Financial® Chief Investment Officer (CIO) Brian Henderson. “The Fed is cutting because rates are very high relative to neutral, not because the economy is collapsing.”

He sees the Fed’s current cycle of rate cuts, which continued in October with another 25-basis-point (0.25%) drop, as the Fed’s path to a neutral Federal Funds rate, which Henderson said they now estimate to be around 3.0%.

With one more Federal Open Market Committee (FOMC) meeting scheduled before the end of the year in December, markets are predicting another 0.25% cut. However, the odds did decline somewhat after Fed Chair Jerome Powell commented that it was not “a foregone conclusion.” If the Fed does cut rates in December, 2025 would end with the Federal Funds rate at a range of 3.5% to 3.75%, compared to 4.25%-4.5% when the year began.

Fixed income managers’ response to falling rates
Meanwhile, fixed income managers are making measured adjustments due to the falling-rate environment. For example, one change they’ve reported is extending duration, which means they’re choosing bonds that will react more strongly to rate changes, usually by holding bonds with longer maturities. That’s because, when rates fall, these longer-duration bonds tend to experience a bigger lift in price.

“We’ve probably extended duration by half a year over the last few months,” said Leslie Lukens Martin, a tax-exempt fixed income portfolio manager for Cavanal Hill Investment Management, a subsidiary of BOKF, NA. “We’re locking in yields that are relatively attractive and positioning for potential price appreciation.”

Martin observed a shift among managers from short-term to intermediate strategies. “We’re seeing movement from five-year to 10-year ladders. It’s all about capturing value while rates are still relatively high.”

Mike Maurer, a senior fixed income portfolio manager for Cavanal Hill, shared a similar perspective. “Normally, we’d be going more toward Treasuries in a falling-rate environment, but this time we’re letting the yield we already have work for us. We’re not rushing to remove risk.”

He added, “Our duration is now in line with benchmarks. We were short for most of 2022 to 2024, which helped, but with 10-year yields already below 4%, there’s limited downside. We might test lower yields briefly, but I don’t think that’s sustainable for longer-duration assets.”

Money market funds also seeking to capture yield
Money market funds tend to follow the Fed’s policy rate closely, so when the Fed lowers rates, yields decline, explained Ryan Friedl, a senior money market portfolio manager for Cavanal Hill. “However, despite declining yields, we’re still seeing assets flow into money market funds. They’re averaging around 4%, which is relatively attractive compared to other safe liquidity options,” he noted.

Since the Fed’s October rate cut was so anticipated, some money market fund managers began extending maturities in preparation. “We saw weighted average maturities increase from 37 to 41 days, industry-wide,” he said. “Some funds are now out to 55 days, pushing the regulatory limit of 60.”

Yet Friedl’s team has taken a more cautious approach. “We haven’t extended quite as far as others. That gives us flexibility to extend later if we see better value,” he explained.

Managers avoiding taking on extra credit risk
At the same time, as credit spreads remain tight, managers are sticking to only higher-credit-quality bonds. “There’s just not enough return right now to justify the additional risk,” Martin said of lower-quality bonds.

Maurer also noted, “Excess yield is hovering near all-time lows. You’re being paid less than almost any time in history to take credit risk, so we’re gradually moving toward higher-quality assets.”

With this in mind, Martin’s team has been focusing on essential service sectors like water and utilities. “People pay those bills before vacations,” she said. “Plus, those municipal governments have rate-setting flexibility.”

Maurer’s team is looking at agency mortgages and select taxable municipal bonds. “Agency mortgages still look attractive compared to other sectors,” he said. “We’re focused on whether we’re being properly compensated for credit and illiquidity risk.”

He also mentioned reducing exposure to less structured mortgages and asset-backed securities. “We want mortgages with a high degree of structure. If they’re too ‘whippy,’ they can bounce around in duration with small rate changes. That’s not what we want right now.”