Now that the Federal Reserve has cracked the interest rate ice, the next development will be to separate winners from losers. Most headlines and popular attention focus on the record-setting stock market indexes, on the premise that cheaper credit is rocket fuel and key rates are heading lower still.
Traders will sooner or later take profits, but do not mistake an ordinary correction born of overexuberance for real trouble until and unless heavy selling metastasizes and lasts longer than a couple of weeks. And that is unlikely as strong economic growth, capital investment, company earnings and steady consumer spending persist in negating any rational case for a switcheroo to a bear market.
Plus, as banks and money market funds pay less and less, high-dividend-yielding stocks, led by financials, utilities, and most sectors of real estate investment trusts (REITs), will see big inflows of cash.
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Banks make wider profit margins on lending when they cut depositors' rates, and one result of that is higher dividends. Several banks have just announced nice dividend boosts, including JPMorgan Chase (JPM) and Fifth Third (FITB). And the busy season for all dividend raises (not only from banks) lies ahead in December and January; 8% and 10% increases are likely to be common.
But my view is mixed and murky with fixed-income (and floating-rate) debt and credit. Here is where you will see winners and losers. High-yield IOUs and tax-exempt bonds are fine, and so are shares of high-interest-rate nonbank lenders.
But I am extra wary of long-term Treasuries and mortgages, and I’m especially wary of passive, total-market-style bond index funds. I would rather accept 3% to 4% from T-bills than trust that government bonds will rally at the longer end of the yield curve.
A good-news-is-bad-news conundrum for bonds
The problem is that many bond traders and fund managers are hardwired to regret sweet economic growth and other positive business and financial news.
As the Fed lowers interest rates to goose the economy, more than a few fear sticky inflation or even another bout of higher readings, notwithstanding all the favorable monthly trends. That explains why the Fed cut sent long-term Treasury and mortgage yields higher, not lower– which sliced bond and bond-fund values. The Vanguard Long-Term Treasury ETF (VGLT) fell 1.3% in a week and a half, while the iShares 20+ Year Treasury ETF (TLT) coughed up 1.6%. This is the wrong place to be.
So why, then, would municipals and high-yield bonds be different? With tax-exempts, it is a net-yield calculation compared with cash – and 3% to 4% tax-free looks better and better as the Fed prepares to trim another 0.5 percentage point from cash returns. Plus, municipals' results lagged earlier in 2024 due to oversupply. But demand is heavy now, and so the returns for munis are improving.
As for high yield, the fortunes correlate closely with stock performance and economic vigor. Both short-term high-yield bonds, as supplied by the PGIM Short Duration High Yield ETF (PSH), and longer-term high-yield funds, such as the Fidelity Capital & Income (FAGIX), yield 5% to 6% with stable-to-rising net asset values.
Again, while Treasury and other taxable bonds had a rough 10 days after the initial Fed cut, Fidelity Capital & Income boosted its net asset value more than 1%, and the fund shows a 9.4% year-to-date return through September 30.
As I often say (and history is on my side), yield rocks. We are about to hear it rock even louder now.
Note: This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.
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