A High-Yield Bond ETF Rallies After the Fed Cuts Interest Rates as a 'Free Ride' in Cash Ends

This week’s edition of ETF Wrap takes a closer look at how U.S. markets have reacted to the Federal Reserve’s significant interest rate cut, as well as strategies for investors seeking income from bonds and stocks in a lower-rate environment.

‍

On Thursday, both U.S. stocks and high-yield corporate bonds rallied after the Federal Reserve implemented a substantial interest rate cut. The central bank lowered its benchmark rate by half a percentage point, which has set off a cycle of rate reductions. Investors are now considering alternative strategies beyond keeping their money in cash, as they anticipate further rate cuts in the near future.

‍

The S&P 500, a key U.S. stock index, hit a new record high, with the SPDR S&P 500 ETF Trust rising by 1.7% year-to-date, achieving a nearly 20% gain according to data from FactSet. High-yield corporate bonds, often referred to as "junk" bonds due to their below-investment-grade ratings, also saw an increase. The iShares iBoxx $ High Yield Corporate Bond ETF finished 0.3% higher on Thursday, with a total return of 7.9% so far this year.

‍

The Fed's decision to cut interest rates is expected to benefit companies with higher debt burdens, as lower rates make borrowing more affordable. Sectors of the stock market sensitive to interest rates may also benefit from this move. However, the lower rates mean that cash savings will generate less income, driving some investors to look for higher yields in other areas of the market.

‍

Brendan McCarthy, global head of ETF distribution at Goldman Sachs Asset Management, pointed out in an interview that the days of getting a 5% yield on cash investments are coming to an end. As the Fed begins to ease its policy, investors are looking to deploy their cash into assets that offer better returns.

‍

For those seeking more attractive returns with minimal volatility, McCarthy suggested a strategy that involves extending the duration of fixed-income assets. He pointed to the Goldman Sachs Access Ultra Short Bond ETF as a good example of this approach. This actively managed ETF focuses on assets with short-term maturities, including Treasury bills, corporate credit, collateralized loan obligations, and agency mortgage-backed securities.

‍

According to FactSet data, this ETF has provided a total return of 4.8% in 2024, outperforming the SPDR Bloomberg 1-3 Month T-Bill ETF, which returned 3.8% during the same period. The latter is a popular choice for investors seeking cash-like securities, as it holds ultra-short-term Treasury bills.

‍

Rick Rieder, BlackRock’s chief investment officer for global fixed income, noted that the Fed’s rate cut will likely have lasting effects on the financial system in the coming months. He expects rates to continue to decline over the next two years, benefiting fixed-income assets. However, he cautioned that the rate cut won’t solve all the uncertainties surrounding the U.S. economy, including the upcoming election and geopolitical risks.

‍

Rieder has expressed a preference for the middle of the yield curve, particularly bonds with maturities of three to five years. He also remains optimistic about high-yield bonds. Rieder leads the BlackRock Flexible Income ETF, which holds a mix of high-yield and investment-grade securities across global fixed-income markets. This ETF has gained 5.9% so far in 2024, surpassing returns from more traditional bond funds like the iShares Core U.S. Aggregate Bond ETF and the iShares Core Total USD Bond Market ETF.

‍

In addition to bonds, investors are also turning to the stock market to generate income. One option is the Pacer Metaurus US Large Cap Dividend Multiplier 400 ETF, which is designed to offer higher income than the dividend yield of the S&P 500. According to Sean O'Hara, president of Pacer ETFs, the fund distributes cash quarterly, providing income equal to 400% of the S&P 500's ordinary yield. The fund invests about 85% of its assets in the S&P 500 and allocates 15% to collateral and dividend futures contracts. So far in 2024, this ETF has gained 15.8%, delivering a total return of 19.1% through Thursday, according to FactSet data.

‍

Another way to diversify income sources within the stock market is through Goldman Sachs’s S&P 500 Core Premium Income ETF and Nasdaq-100 Core Premium Income ETF. Both funds utilize covered-call strategies to provide monthly distributions, although this strategy sacrifices some of the potential upside in exchange for regular income. In 2024, the S&P 500 Core Premium Income ETF has returned 17.7%, while the Nasdaq-100 Core Premium Income ETF has gained 16.4%, according to FactSet.

‍

As the Fed’s rate-cutting cycle continues, investors will likely need to adjust their strategies to find income in a lower-rate environment. Fixed-income assets stand to benefit, but the days of easy gains from parking cash in Treasury bills may soon be over. The search for higher yields is prompting a shift towards riskier assets, such as high-yield bonds and dividend-focused ETFs.

‍

In conclusion, the recent rate cut has spurred market gains and opened up new income opportunities for investors. While bonds remain an attractive option for those seeking stability, dividend-focused strategies in the stock market can also provide a reliable source of income in the months ahead. As always, it’s essential to consider a diversified approach to capture returns across different asset classes.

‍