By Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) – Bond investors are keeping a defensive but neutral stance in managing portfolios ahead of this week's Federal Reserve policy meeting, overshadowed by the uncertain U.S. presidential election.

Investors expect the U.S. central bank's Federal Open Market Committee to cut its benchmark interest rate by 25 basis points to a range of 4.50%-4.75% at the end of its two-day meeting on Thursday, delayed one day due to the election. The Fed previously cut its policy rate by 50 basis points during its easing cycle beginning in September.

The election has dominated attention for bond investors recently, causing them to adopt a cautious approach with their allocations until a winner is determined.

All year, bond investors have extended duration by purchasing longer-dated assets in anticipation of Fed easing and possible recession. This strategy remains prevalent even post-election.

If rates drop, bond prices are expected to rise, and historically, long-dated securities outperform shorter-duration assets like cash and Treasury bills during rate-cutting cycles.

"We have initiated small, long positions on the curve, but overall we're closer to neutral," said Brendan Murphy, head of fixed income, North America, at Insight Investment, which manages $838.1 billion in assets.

"What's preventing us from being more aggressive is the uncertainty surrounding the election. We prefer to wait and see."

Janet Rilling, senior portfolio manager and head of the Plus Fixed Income team at Allspring Global Investments, emphasized a neutral stance due to the Fed's data-dependence, U.S. economic volatility, and the election's unpredictability.

"Making predictions about election outcomes and positioning for them doesn’t make sense. We prefer to remain flexible to evaluate our positions after results are in," Rilling noted.

Recent weeks have seen position-squaring among institutional investors, indicating caution before the election and Fed meeting. Asset managers have used long contracts in Treasury futures to address portfolio needs.

Commodity Futures Trading Commission data shows a reduction in net long positions on U.S. 10-year note futures that peaked on October 1. Other Treasury futures participants have also tapered extreme long or short positions.

SEARCHING FOR OPPORTUNITIES

Volatility has risen ahead of the election, with the MOVE index, a measure of rates volatility, reaching 135.18 last Thursday, its highest level in over a year. This suggests Treasury yields could change by at least 8.5 basis points daily in either direction for the following month. On Friday, it was at 132.6.

Harley Bassman, creator of the MOVE index and managing partner at Simplify Asset Management, stated options prices predict a significant shift of 18 basis points in Treasury yields on November 6 or 7.

National polls indicate a close election between Republican Donald Trump and Democratic Vice President Kamala Harris. Recent online prediction markets, which initially favored Trump, now show Harris gaining ground.

The "Trump trade" in bonds has emerged due to rising Treasury yields as investors sold notes and bonds, despite the Fed's rate cuts. Trump's economic policies, likely to increase inflation and the U.S. fiscal deficit, have raised concern among economists.

With increasing yields and volatility, investors are reluctant to make significant moves. However, some see the current climate as an opportunity.

Clayton Trick, head of portfolio management at Angel Oak Capital Advisors, managing $17 billion, finds agency mortgage-backed securities appealing due to their typically higher yields than Treasuries.

Allspring's Rilling suggests that investors might still increase duration or switch to longer-dated assets, especially given the recent rise in yields, starting with cash to short-duration assets before transitioning to intermediates.

"The short-term dynamics may be volatile, presenting chances to extend duration," Murphy from Insight concluded.