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Fixed-Income Insights

Here’s why investors who want to reduce risk in their core bond allocation may want to take another look at short-duration credit.

The move in the 10-year U.S. Treasury bond has been getting a lot of attention lately.  With its yield approaching 2.85% (as of February 2), this benchmark has jumped more than 80 basis points (bps) since early September 2017. This rise in Treasury yields has led to a loss of -1.82% for the representative Bloomberg Barclays U.S. Aggregate Bond Index (a broad measure of U.S. bond market performance), which has a heavy weight in U.S. Treasuries and government-related securities.

But the real move in rates has come at the short end of the yield curve: the two-year U.S. Treasury bond yield recently has reached 2.17%-an increase of over 100 bps in the past 12 months, and nearly 200 bps from the lows in early 2013 (see Chart 1).

The move to higher short-term rates is to be expected, as the two-year bond yield has historically been closely tied to moves in the U.S. Federal Funds target rate, and expectations for future rate moves by the U.S. Federal Reserve (Fed).  Over the past few years, the Fed has been very clear on its intention to slowly normalize monetary policy, and has gradually raised rates with 25 basis point hikes in December 2015, December 2016, and three additional hikes in 2017.  Most market participants expect an additional three to four rate hikes in 2018, assuming economic data continues to show the U.S. economy remains on its current path.      

As we highlighted in a recent Market View (“Playbook for Rising Rates), there are several sectors of fixed income that historically have fared well during periods of rising Treasury yields, including short maturity corporate bonds.  Rising short-term rates often are cited as a reason to avoid short-maturity bonds.  The common assumption is that as the Fed raises short-term rates, short-term yields increase more than long-term yields, causing the yield curve to flatten, and leading to negative returns on short-term bonds.

While it is true that short-term yields tend to rise more than long-term yields during the Fed’s monetary policy-tightening cycles, many overlook the impact on performance. Since these securities have low duration, the move in yields has a muted impact on prices of short-maturity bonds relative to those with longer maturities.  The total return on any bond investment has two major components: the change in price and the income generated.  Since the changes in price typically are muted due to the low duration of short-maturity bonds, the income generated is in general a large component of total return.  So, as short rates increase, the modest price declines are often more than offset by the income, leading to positive total return.

Table 1 summarizes how that has played out during this recent bout of activity. Short-term Treasuries (as measured by the ICE BofAML 1-3 Year U.S. Treasury Index), have had just slightly positive returns over the trailing one-, three-, and five-year periods.  With the two-year Treasury starting with a yield of less than 20 bps five years ago, there was very little yield in short-term Treasuries to offset the negative impact of rising yields.

A different story plays out as one moves to the more credit-sensitive sectors of the market. Short-term investment-grade corporate bonds and commercial mortgage-backed securities (CMBS), for example, historically have generated much higher returns than government-related securities. While the low duration of these securities has led to a limited price impact from higher rates, they have benefited from the higher income from their additional spread over Treasuries, which has led to positive total returns. 

As rates have been moving higher, short-maturity strategies also have had the benefit of regular cash flows from coupon payments and maturities, which can be reinvested at prevailing higher rates. Thus, reinvested or new funds placed in short-maturity securities will likely be starting at a higher initial yield, creating the potential for higher income and total return in the future.  

For example, the average yield to maturity of 2.65% on the ICE BofAML1-3 year Corporate Bond Index is about 150 bps higher than the 1.14% yield on the index five years ago. So, while short-term corporate bonds historically have been able to generate positive returns in the face of rising rates over the past five years, the higher yields available today create a more favorable starting point for potential returns going forward.

How Have Lord Abbett’s Short-Duration Strategies Fared During This Period?
The Lord Abbett Short Duration Income Fund takes a flexible, multi-sector approach to investing in short maturity bonds. Rather than focusing on U.S. Treasuries and government-related securities, the strategy also invests across a diversified mix of short-maturity securities, including investment-grade corporate bonds, CMBS, and asset-backed securities, with select exposure to below investment-grade securities.  In addition, while the portfolio maintains a consistent effective duration, with a true short maturity and short duration profile, it also has the flexibility to adjust its sector allocations in order to adapt to the market environment.

As illustrated in Chart 2, over the past year, while the two-year Treasury yield has increased by 100 bps, the Short Duration Income Fund has generated positive returns, well ahead of short-term Treasuries and short-term corporate bonds, and has placed in the top quartile of its peers in the Morningstar Short Term Bond category. Over the past three- and five-year periods, the Fund has outperformed more than 90% of its peers in the Short Term Bond category. It also has generated higher returns than the longer-duration Bloomberg Barclays Aggregate Index, and has done so with less than half of the volatility of the index. This occurred over a period when the two-year Treasury yield increased by over 200 bps, and there was significant flattening of the yield curve—a period when short-duration strategies should have faced significant headwinds.

It is important to note that not all fixed-income sectors react the same way to economic and interest-rate changes. Bonds are affected by interest-rate movements.

Bond prices and, likewise, a bond fund’s share price generally move in the opposite direction of interest rates. As the prices of bonds in a fund adjust to a rise in interest rates, a fund’s share price may decline. Investors should be aware of the special risks involved with investments in high-yield bonds and floating-rate loan funds. High-yield bond funds invest in lower-rated, higher-yielding instruments, which are subject to increased risk of default and can potentially result in loss of principal. Mortgage-backed securities are susceptible to prepayment risk. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. For this reason, it is essential to make sure the fixed-income allocation of your portfolio is well diversified. Please remember that past performance is not a reliable indicator or guarantee of future results.

Going Forward
With the large move in yields, leading to negative returns in the Bloomberg Barclays Aggregate Index, investors once again may be reconsidering their core bond allocations.  Short-maturity credit sectors have weathered the headwinds of rising short-term rates, and have generated positive returns with relatively low volatility; and now may offer higher yields than what has been available in recent years. Given this return profile, investors who want to reduce the risk in their core bond allocation may want to take another look at short-duration credit.

 

Chart 1. The Two-Year U.S. Treasury Yield Has Increased by 200 Basis Points

Source: Bloomberg The information shown is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.   Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a reliable indicator or a guarantee of future results.

 

Table 1. Short Credit Has Performed Well in the Face of Rising Rates
Risk-adjusted returns, 01/01/2013-01/31/2018

1 ICE BofAML 1-3Y US Treasury  2 ICE BofAML 1-3Y US Corp  3 ICE BofAML 1-3Y BBB US Corp  4 Bloomberg Barclays CMBS IG 1-3.5Yr 5 Bloomberg Barclays HY 1-3 Index 6 Bloomberg Barclays US Agg Bond TR USD
Source: Bloomberg.  The information shown is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.  Past performance is not a reliable indicator or a guarantee of future results.

 

Chart 2. Lord Abbett Short Duration Has Had Positive Historical Returns in the Face of Rising Rates
Risk-adjusted returns, 01/01/2015-12/31/2017

AVERAGE ANNUAL TOTAL RETURNS FOR CLASS F SHARE INVESTMENTS AS OF 12/31/2017, INCLUDING THE REINVESTMENT OF ALL DISTRIBUTIONS:
1-YEAR: 2.63%; 3-YEARS: 2.41%; 5-YEARS: 2.11%; 10-YEARS: 4.23%; EXPENSE RATIO: 0.50%
Source: Morningstar. Morningstar ranked the Lord Abbett Short Duration Income Fund class F share 36, 24, and 6 among 462 , 399, and 257 Short-Term Bond Funds for the 3, 5, and 10-year periods ended 12/31/2017, respectively. Rankings in the Morningstar Funds Category reflect all share classes within the category and are based on total return and do not reflect the effect of sales charges. The fund is ranked within a universe of funds similar in investment objectives. A fund’s absolute rank in a Morningstar Category serves as the basis for a calculation determining the fund’s total return percentile rank against others in the category. With this method, percentile ranks always range from 1 (best) to 100 (worst) with all intermediate values spread evenly over that range. Past performance is not a reliable indicator or guarantee of future results. Current performance may be higher or lower than the performance quoted. The investment return and principal value of an investment in the Fund will fluctuate so that shares, on any given day or when redeemed, may be worth more or less than their original cost. You can obtain performance data current to the most recent month-end by calling Lord Abbett at 888-522-2388 or referring to lordabbett.com. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

A Note about Risk: The Short Duration Income Fund is subject to the general risks associated with investing in debt securities, including market, credit, liquidity, and interest rate risk. The value of an investment will change as interest rates fluctuate and in response to market movements. When interest rates fall, the prices of debt securities tend to rise, and when interest rates rise, the prices of debt securities are likely to decline. Debt securities are subject to credit risk, which is the risk that the issuer will fail to make timely payments of interest and principal to the Fund. The Fund may invest in high yield, lower-rated debt securities, sometimes called junk bonds and may involve greater risks than higher rated debt securities. These securities carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. The Fund may invest in foreign or emerging market securities, which may be adversely affected by economic, political, or regulatory factors and subject to currency volatility and greater liquidity risk. The Fund may invest in derivatives, which are subject to greater liquidity, leverage, and counterparty risk. These factors can affect Fund performance. The Fund's portfolio is actively managed and is subject to change.

Additional risks to consider:  The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As interest rates rise, the prices of debt securities tend to fall. Distressed and defaulted securities are speculative and involve substantial risks in addition to the risks of investing in junk bonds, including a higher risk of default.

High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Lower-rated bonds carry greater risks than higher-rated bonds. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer maturity of a security, the greater the effect a change in interest rates is likely to have on its price. No investing strategy can overcome all market volatility or guarantee future results.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

basis point is one one-hundredth of a percentage point.

Duration is the change in the value of a fixed-income security that will result from a 1% change in market interest rates. Generally, the larger a portfolio’s duration, the greater the interest-rate risk or reward for underlying bond prices.

A bond yield is the amount of return an investor will realize on a bond. Though several types of bond yields can be calculated, nominal yield is the most common. This is calculated by dividing the amount of interest paid by the face value.

Yield to maturity is the rate of return anticipated on a bond if held until it matures. Yield to maturity assumes all the coupon payments are reinvested at an interest rate that equals the yield-to-maturity. The yield to maturity is the long-term yield expressed as an annual rate.

The ICE BofAML 1-3 Year U.S. Corporate Index is an unmanaged index comprised of U.S. dollar denominated investment grade corporate debt securities publicly issued in the U.S. domestic market with between one and three year remaining to final maturity.

The ICE BofAML 1-3 Year US Treasury Index  is a subset of the ICE BofAML US Treasury Index including all securities with a remaining term to final maturity less than 3 years.

The ICE BofAML  0-3 Year U.S. Asset Backed Securities Index is a subset of the BofA Merrill Lynch U.S. Asset Backed Securities Index including all securities with an average life less than 3 years.

The ICE BofAML BBB-Rated 1-3 Year U.S. Corporate Index is an unmanaged index comprised of U.S. dollar-denominated investment-grade corporate debt securities publicly issued in the U.S. domestic market with between one and three years remaining to final maturity.

The ICE BofAML Government Master Index is a market capitalization-weighted index including all U.S. Treasury notes and bonds, with maturities greater than or equal to one year and less than 10 years and a minimum outstanding of $1 billion.

Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofAML INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofAML INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD ABBETT, OR ANY OF ITS PRODUCTS OR SERVICES.

The Bloomberg Barclays 1-3 Year Asset-Backed Securities Index is a maturity-specific component of the Bloomberg Barclays Asset-Backed Securities (ABS) Index, the ABS component of the Bloomberg Barclays U.S. Aggregate Index.

The Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The Index covers the U.S. investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.

The Bloomberg Barclays U.S. 1-3 Year Government Bond Index is an unmanaged index that includes U.S. government Treasury and agency securities with maturities of 1 to 3 years.

The Bloomberg Barclays U.S. 1-3.5 Year CMBS Investment Grade Index measures the market of conduit and fusion CMBS deals with a minimum current deal size of $300 million. The index includes bonds that are ERISA eligible under the underwriter's exemption.

The Bloomberg Barclays U.S. 1-3 Year High Yield Bond Index is the 3 Year (1-2.9999) component of the Barclays U.S. High Yield Bond Index. The Barclays U.S. High Yield Bond Index covers the universe of fixed rate, non-investment grade debt. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are included.

The Bloomberg Barclays U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moody’s, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

This article is being provided for informational purposes only. References to any specific securities, sectors or investment themes are for illustrative purposes only and should not be considered an individualized recommendation or personalized investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described above.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for Use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

Investors should carefully consider the investment objectives, risks, charges and expenses of the Lord Abbett Funds. This and other important information is contained in the fund's summary prospectus. and/or prospectus. To obtain a prospectus. or summary prospectus. on any Lord Abbett mutual fund, you can click here or contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388. Read the prospectus. carefully before you invest or send money.

Not FDIC-Insured. May lose value. Not guaranteed by any bank. Copyright © 2018 Lord, Abbett & Co. LLC. All rights reserved. Lord Abbett mutual funds are distributed by Lord Abbett Distributor LLC. For U.S. residents only. 

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education.  None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity.   If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

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