For years after the financial crisis, many investors were resigned to earning next to nothing on their cash and short duration investments. Rising interest rates, however, have brought a new reality: The front end of the fixed income market looks attractive for the first time in almost a decade. In fact, short-term yields look much more attractive than many stock dividends and longer-dated fixed income instruments.
Much like Dorothy in "The Wizard of Oz," investors are suddenly waking up to a bright new world: The trend toward higher rates has fundamentally altered the investment landscape and appetite for risk.
The primary reason for the new reality is the Federal Reserve. For more than two years, the Fed has worked to remove its post-crisis emergency policy measures, raising the fed funds rate six times to its current range of 1.5%–1.75% and reducing the size of its balance sheet. PIMCO believes rates will continue to rise in 2018 and 2019, making investment strategies with limited interest rate exposure attractive for both their returns and their low volatility.
Here are five reasons to like the front end of the U.S. bond market:
- Positive absolute return potential: Higher-yielding short-term investments can help hedge bond portfolios from the impact of rising rates − their shorter durations mean they have lower sensitivity to interest rate changes. For example, interest rates would have to increase more than 400 basis points (bps) before short U.S. Treasury bonds would post negative absolute returns in the current rate and yield curve environment. This compares to around only 25 bps in cushion for long duration U.S. Treasuries, just over 50 bps for intermediate Treasuries and just over 100 bps for low duration Treasuries (for details on this, see our Smart Chart on front-end yields).
- Low volatility: Investment grade bonds with maturities under two years ‒ including Treasuries, corporate bonds and most structured products ‒ exhibit several qualities that can minimize volatility. Most investment grade front-end bonds, for example, are typically held to maturity. Because these bonds are mostly in steady hands, prices tend to remain relatively stable. Historically, volatility in short-term strategies over a 10-year period is less than 1% annualized, and often much lower depending on the strategy; that compares with about 15% annualized volatility in equities and 10% for long duration bond strategies.*
- Higher Libor rates: Since November, the difference between Libor and the Overnight Index Swap rate (LOIS) has widened to almost 50 bps as T-bill issuance has increased, among other factors. Libor rates affect all asset prices, but particularly those with shorter maturities and credit exposure. The LOIS spread widening has translated one-for-one into higher three-month commercial paper rates and, by extension, into yields on corporate bonds with maturities of a year or less.
- Positive real return potential: Even though U.S. inflation remains historically low – core CPI is at 2.1% annualized as of April – it can still quickly erode real principal on investments with returns below that level. Short-dated bonds with current yields of 2.5%‒3.5%, however, have greater potential to preserve investors’ purchasing power.
- Low cost of liquidity: Transaction costs for short-term bonds tend to be low. On a one-year note, an institutional investor typically pays only $0.05 for a round-trip transaction (buying and subsequently selling) in the current market. The same investor buying and selling a five-year note would often pay five times that. In other words, the cost of liquidity is higher for longer-maturity bonds. This makes the front end an attractive place to park while awaiting more symmetric risks on longer-term investment allocations.
With increasingly attractive valuations and no sign on the horizon of economic imbalances, the front end of the bond market represents an opportunity for investors now. Diversified short-term bond strategies, which aim to find the best opportunities for high-quality yield, can help investors de-risk a higher-volatility portfolio and at the same time potentially benefit from rising yields as the Fed continues to tighten.
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