Since the outcome of the November 2024 U.S. election, uncertainty regarding the future path of interest rates has increased as investors grapple with the potential impacts of the new administration’s policies on inflation, economic growth, and the labor market.

While hopes for rate cuts have cooled due to the risk of stickier inflation under Trump 2.0, the Federal Reserve (Fed) is still on course to cut rates through 2025 and 2026, albeit at a far slower pace than what was being predicted pre-election. Futures markets are now anticipating just 69 basis points (bps) of rate cuts over the next 24 months, bringing the effective federal funds rate to around 3.65%, from the current 4.33%.

Nevertheless, with the prospect of lower interest rates, investors may be asking the following questions:

Should I rotate out of short duration into long-duration bonds? If I do maintain an allocation to short duration, which sectors might best suit my investment goals? Should high-quality, floating-rate bonds still command a strategic allocation in my fixed income portfolio?

Why maintain an allocation to short duration through a rate-cutting cycle?

Historically, most of the move down in long-term yields has taken place before the Fed starts cutting, not after (i.e., long-term yields generally move in anticipation of rate cuts). The current cycle is no exception, with the 10-year U.S. Treasury yield rallying to 3.62% in September 2024 before backing up to around 4.63% in January 2025.

While long-term yields could rally further, the market is anticipating they will not do so unless we enter a recession or inflation falls much more than expected. As shown in Exhibit 1, short-term yields are projected to fall over the next two years, with a smaller change to 10-year and 30-year Treasury yields.

What does this mean for investors?

1. We believe investors should not indiscriminately rotate from short- to long-duration bonds simply because rate cuts are imminent. Investors who do so may be disappointed if long-term yields do not decline as much as they’d hoped. Maintaining an allocation to short duration adds diversification, while also providing a buffer in case rates do not fall as quickly as expected.

2. We believe investors should continue to lean into the attractive yields at the front end of the yield curve. Rate cuts are expected to be slow and gradual over the next 24 months, underpinning a higher-for-longer rate environment that is supportive of short-duration fixed income.

3. Investors who are concerned about a recession might complement their short-duration holdings with a long-duration asset that carries virtually no credit risk – such as agency mortgage-backed securities (MBS) – to provide some portfolio defense.

What options do investors have for filling their short-duration bucket?

As rates have moved higher in recent years, investors have flocked to short-duration corporate bonds or cash/money market funds to fill their short-duration bucket. But while the yields are enticing, we believe these sectors may not be the optimal choice for long-term investors.

According to our analysis, investors will likely be better served with an allocation to AAA rated collateralized loan obligations (CLOs), for the following reasons.

1. Spread return matters, especially when rates go lower

AAA CLOs have historically paid a higher credit spread – or additional income above the risk-free rate – than short-duration investment-grade (IG) corporates and cash. On average, between January 2015 and January 2025, AAA CLOs paid an additional 142 bps over the risk-free rate, compared to 69 bps for short-duration IG corporates and 0 bps for cash/money market funds.

As shown in Exhibit 2, these spread differences might appear less significant when rates are hovering around their multi-decade highs. However, when rates start to decline, the additional income paid by AAA CLOs will become a greater proportion of the total yield and will also help investors to continue to receive an income stream even if rates go to zero.

In contrast, cash and money market funds pay nothing when rates go to zero, leaving investors without an income stream from their short-duration holdings.

As shown in Exhibit 3, the additional credit spread paid by AAA CLOs has translated into higher cumulative total returns versus short-duration IG corporates and cash.

2. Higher yields need not come at the cost of lower credit quality

At an index level, AAA CLOs exhibit higher credit quality than short-duration IG corporates. Investors may increase yield while also improving the overall credit quality of their portfolios by incorporating an allocation to AAA CLOs.

3. The precedent of 2019’s rate-cutting cycle

In our view, investors who remain concerned about short duration in a declining rate environment may find it helpful to compare today’s environment to the second half of 2019 – the most recent rate-cutting environment.

The Fed made three rate cuts of 25 bps each during the second half of 2019, taking its benchmark rate from 2.5% to 1.75% by year end. (The Fed subsequently cut rates to zero in March 2020 with the onset of COVID-19).

At that time, the yield curve was slightly inverted (3-month versus 10-year inversion peaked at -51 bps), and Fed rate cuts resulted in the curve flattening out. Today, we also anticipate the yield curve to steepen from its flat position as the Fed moves forward with rate cuts.

As shown in Exhibit 5, AAA CLOs continued to generate consistent positive returns amid these rate cuts. Once again, the credit spread within AAA CLOs supported ongoing income returns. While short-duration IG corporates marginally outperformed AAA CLOs during that period, they did so with far higher volatility.

4. Lower-correlation volatility and improved risk-adjusted returns

Some investors – not wanting to put their short-term cash reserves at risk – may feel uneasy with any volatility within their short-duration bucket. (As represented by average rolling 1-year standard deviation in Exhibit 6, AAA CLOs and short-duration IG corporates do exhibit some volatility in contrast to cash, which is essentially a zero-volatility asset.)

However, we believe many investors are too cautious in this regard and could handle more volatility in their short-duration bucket in exchange for higher potential returns. Historically, despite occasional drawdowns, AAA CLOs have still ended up comfortably ahead of cash over the long term.

Further, while drawdowns do occur in AAA CLOs, they are relatively small compared to other risk assets, have not been common historically, and the asset class has typically recovered within one or two quarters. In our view, aside from maintaining a modest cash allocation for immediate needs (0-3 months), we believe investors would be better served over the long term by taking on a small amount of volatility to improve their portfolio’s income-earning potential.

As shown in Exhibit 7, adding CLOs to the Bloomberg U.S. Aggregate Bond Index (U.S. Agg) may have improved long-term risk-adjusted returns by increasing total return while also reducing standard deviation.

Conclusion

We believe investors should maintain diversification within their fixed income portfolios throughout the interest rate cycle. Therefore, in our view, an allocation to short duration remains highly relevant in the current environment, particularly considering how attractive short-term yields are.

Further, optimizing total return for one’s entire portfolio is vital to improving long-term risk-adjusted returns. We believe a strategic allocation to AAA CLOs, with their attractive floating-rate yields, high credit quality, and low correlation to other fixed income sectors, remains a key component of a strategic fixed income allocation.

IMPORTANT INFORMATION

Collateralized Loan Obligations (CLOs) are debt securities issued in different tranches, with varying degrees of risk, and backed by an underlying portfolio consisting primarily of below investment grade corporate loans. The return of principal is not guaranteed, and prices may decline if payments are not made timely or credit strength weakens. CLOs are subject to liquidity risk, interest rate risk, credit risk, call risk and the risk of default of the underlying assets.

Derivatives can be more volatile and sensitive to economic or market changes than other investments, which could result in losses exceeding the original investment and magnified by leverage.

Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.

Fixed income securities are subject to interest rate, inflation, credit and default risk.  The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa.  The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

Mortgage-backed securities (MBS) may be more sensitive to interest rate changes. They are subject to extension risk, where borrowers extend the duration of their mortgages as interest rates rise, and prepayment risk, where borrowers pay off their mortgages earlier as interest rates fall. These risks may reduce returns.