Instead of focusing on the ultra short end of the yield curve, CIO sees opportunities in high-quality medium to long duration fixed income. (ddp)

The rise partly reflects more hawkish rhetoric from top Federal Reserve officials, as well as the prospect of increased near-term issuance if the debt ceiling issue is resolved. On Thursday, Dallas Fed President Lorie Logan said that the latest economic data did not yet justify a pause in rate hikes at the central bank’s June meeting.

But we believe the appeal of cash deposits and money market funds is likely to prove short-lived. House Speaker Kevin McCarthy has said “an agreement in principle” between the parties on the debt ceiling is possible this weekend. Moderating default risks already started to push the yield lower on the 1-month US Treasury, which is down 23 basis points from a two-decade high on Monday. In addition, despite recent indications that a Fed rate hike in June remains possible, an end to the cycle is not far away, and our base case remains that the central bank will not raise rates any further.

With cash rates likely approaching a peak, investors should act soon to seek more quality sources of income before markets start to price much lower interest rates. We see several ways of doing this:

Lock in higher yields in fixed income markets. Instead of focusing on the ultra short end of the yield curve, we see opportunities in high-quality medium to long duration fixed income. While yields on 2- and 5-year US Treasuries are down from their recent peak in early March—which was prior to the emergence of worries over the health of the banking system—yields remain attractive, at 4.21% and 3.65% respectively. We see the potential for capital gains in the event growth slows more abruptly than currently expected. Equally, investment grade bond returns should outperform in tougher economic times.

We also see upside for US dollar emerging market sovereign debt. Although the speed and breadth of China’s economic recovery has disappointed, we still expect GDP growth to pick up to around 5.7% this year, from 3% in 2022. This should help emerging market sovereign bonds; the current yield of 8.7% for the JP Morgan EMBIG Div indexlooks attractive, in our view.

Investors can also find attractive income opportunities in the equity markets, through high dividend and quality stocks. The MSCI World High Dividend Yield index is offering 4.2% yield. These equities are mostly in more defensive parts of the markets and are relatively resilient when the economy slows—as we expect these dividend payments to be relatively stable even in the event of a recession, based on historical experience. And since companies in this category often have strong pricing power, enabling them to pass on higher costs to customers, this part of the equity market should perform well while inflation remains above central bank targets.

Real assets along with yield generating structured investments offer alternative ways to add durable returns. Exposure to “real assets,” including commodities, infrastructure, and real estate, can provide investors with additional portfolio diversification and income, as well as the potential for long-term inflation mitigation. We currently see appeal in direct and indirect infrastructure exposure and direct commodity exposure.

Strategies involving options selling have particular appeal at present, in our view. Such strategies tend to outperform in range-bound equity markets, which is what we expect for the remainder of 2023. Also, the volatility risk premium is relatively high at present, meaning that actual swings in equity markets have been low relative to implied volatility measures. That increases the potential gains for investors from selling options.

So, we advise investors against assuming that current cash and money market yields will last for long. Building durable income into portfolios will be increasingly important if, as we expect, the recent equity rally runs into headwinds in the rest of the year.

Main contributors - Mark Haefele, Christopher Swann, Vincent Heaney, Luca Henzen, Jon Gordon

Content is a product of the Chief Investment Office (CIO).

Original report - Adding durable income to portfolios, 19 May 2023.