Ready For Recession? Fund Managers Advocate Shift To Treasury, Mortgage Bonds

Investors have accumulated record amounts of cash and equivalent assets as a way to hedge against the volatility of recent times.

Now, fund managers are urging investors to put that money to work, as decreasing inflation and the potential for an economic slowdown may lead to profitable opportunities in the bond markets.

According to ICI Global, capital invested into money market fund assets reached a record of $5.73 trillion last week. Money market funds are characterized by having very low volatility and very high liquidity, holding large amounts of cash and other low-risk securities in their portfolios.

Investors tend to lean towards money market investing in times of uncertainty, when availability of cash is a prime concern and tolerance to risk is low. Money market funds give better returns than cash deposits on banks, which is why investors have been flocking towards these assets since the Fed began its tightening cycle last year, which has now taken the federal funds rate to between 5.25% and 5.50%.

But, with inflation dropping to more comfortable levels, bond managers are suggesting that now is an optimal time to allocate some of those assets into the bond market.

Minutes from the Federal Open Market Committee’s November meeting revealed that Fed participants view the current interest rate level of between 5.25% and 5.5% as restrictive, potentially signaling the end of their intensive rate hike campaign in light of recent positive inflation data and acknowledging the significant tightening of financial conditions in recent months.

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Greg Whiteley, head of Government Securities Investing at DoubleLine told Bloomberg that the range of 4.5% to 5% yield "is a safe place to be buying bonds."

The two-year treasury bond currently yields at 4.89% while the 5- and 10-year bonds have a yield of 4.44%.

Whiteley and other fund managers contend that the Federal Reserve’s actions are effectively slowing down the economy, a necessary step to reduce inflation back to the 2% target. Economist Gary Shilling this week predicted that a recession is imminent, potentially including a 30% drop in stock values, which further supports the strategy of redirecting investments towards safer and comparatively higher-yielding assets such as bonds.

Piper Sandler strategist Michael Kantrowitz echoed the same prediction over the weekend, based on several data points coming from housing, profits, and employment. 

The housing market showed a slight uptick last week but continues at historically low levels, with mortgage rates sustaining prices that are unaffordable for the majority of homebuyers.

Other economists, however, lean towards a soft-landing scenario, which would mean a return to pre-pandemic inflation levels without a recession.

Bond fund managers argue that sticking to cash "means you miss all the potential price appreciation if the economy starts to slow," as Ryan Murphy of Capital Group told Bloomberg.

The managers also pointed to mortgage bonds as a sector that could lift off next year if interest rates come down. Mortgage-backed securities consist of pools of mortgages that lenders bundle together and sell as securities to third parties in order to free up more cash to continue lending.

While these securities gained a bad reputation for their role in the 2008 financial crash, increased regulation has made them appealing again. Although they still carry more risk than cash or government bonds, they're generally considered less risky than corporate bonds, because there’s real estate as collateral, and they carry less volatility than stocks.

These include Vanguard Total Bond Market ETF BND and iShares Core US Aggregate Bond ETF AGG for the broad ranging bond market, and iShares MBS ETF MBB as well as Vanguard Mortgage-Backed Securities ETF VMBS for specific exposure to mortgage-backed securities.

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