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Fixed-Income Insights

Short-duration corporates have outperformed Treasuries during the past five tightening cycles.

 

In Brief

  • Fed tightening typically leads to yield curve flattening.
  • During such periods, short maturities historically have delivered positive returns, despite rising yields, due to their short duration.
  • Higher income generated by short-maturity, credit-sensitive sectors offer greater prospects for returns in the face of rising rates.

 

For much of the past five years, many bond investors have been afraid of the potential for rising interest rates. U.S. Treasury bonds have traded near historically low yields since the financial crisis of 2008–09, and a return to a more "normal" interest-rate environment could lead to higher yields, lower prices, and negative returns on high-grade bonds. With this in mind, investors have moved to lower-duration strategies to reduce their exposure to rising interest rates. (Duration is a measure of a bond's interest-rate sensitivity: for a given change in yield, longer-duration bonds experience a larger change in price.)

This fear came to fruition in 2013, as the yield on the 10-year Treasury rose from 1.6% in May to close the year just north of 3.0%, according to Bloomberg. But the pattern reversed in 2014, with the 10-year Treasury once again approaching a 2.0% yield to maturity, generating very strong returns for longer-duration government bonds. 

As we look forward to 2015, the fear of higher rates is once again in the front of investors' minds. While many parts of the globe are struggling, the U.S. economy appears to have stabilized, generating positive gross domestic product (GDP) growth and an improving employment picture. With this as a backdrop, most expect the Federal Reserve to end its long-standing policy of pegging its target fed funds rate near zero, and to begin raising short-term rates in mid-2015. 

Given the very low level of inflation in the United States, combined with economic troubles overseas, it is not likely that the Fed will want to take an overly aggressive stance by raising short-term rates sharply.  Instead, a more gradual move may be more likely. According to a recent Bloomberg Survey, most economists expect an initial rate hike in mid-2015, with subsequent moves at every other meeting, as opposed to every meeting, thereafter. (For more insights on recent Fed comments, see "The Fed: Just a Little Patience," by Zane Brown.)

In anticipation of Fed actions, some have turned their attention to the risks of rising rates on short-maturity bonds. Since short-term bond yields are more closely tied to the fed funds rate than are longer-maturity bond yields, the argument goes, short bonds are more susceptible to losses when the Fed begins to raise rates. As the Fed tightens, short-term yields increase more than long-term bond yields, causing the curve to "flatten." So does this mean that investors should avoid short-term bonds? History would suggest this is not the case.

It is true that short-term yields do tend to rise more than long-term yields during Fed tightening cycles.   However, since they are shorter in duration, this leads to a more muted impact on bond prices. We have examined the stability of returns in short maturities in a previous Market View on lordabbett.com.  According to government bond index data since 1978, there were nine calendar years in which the 10-year Treasury bond generated negative returns. By comparison, as illustrated in Chart 1, the short-term Treasuries (as represented by the BofA 1-3 Year U.S. Treasury Index) has been positive in every year.  For short-term corporate bonds (represented by the 1-3 Year U.S. Corporate Index), the credit crisis of 2008 was the only blemish. Of course, this 35-year period includes several episodes of Fed tightening.

 

Chart 1. Short Maturities Have a History of Generating Positive Returns
Annual returns, January 1, 1978 – December 31, 2013

Source: Morningstar. 1-3 Year Treasuries represented by the BofA Merrill Lynch 1-3 Year U.S. Treasury Index; 1-3 year corporates represented by the BofA Merrill Lynch 1-3 Year U.S. Corporate Index.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is no guarantee of future results.  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 rates rise, prices tend to fall. 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.

 

Table 1 details more closely the past five Fed tightening cycles, and the record shows:

  • The yield curve typically "flattens," with two-year bond yields rising more than 10-year bond yields in four out of five episodes.
  • Two-year Treasury bonds generated positive returns in every period.
  • One- to three-year corporate bonds outperformed two-year Treasuries in every period.
  • One- to three-year corporates outperformed 10-year Treasuries in every period, by an average of more than 5.0%.

 

Table 1.  In the Last Five Fed Tightening Cycles, Short-Term Corporate Securities Have Outperformed Treasuries

Source:  Morningstar. 10-year Treasuries represented by the Citi Treasury Benchmark 10 Year Index.  2-Year Treasury Performance represented by the Citi Treasury Benchmark 2 Year Index. 1-3 year corporate securities represented by the BofA Merrill Lynch 1-3 Year U.S. Corporate Index.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Performance during other time periods may differ. Due to market volatility, the market may not perform in a similar manner in the future. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is no guarantee of future results.

 

These periods illustrate that the change in yield does not tell the whole story. One must consider what the price impact of that change in yields would be, given the duration of the bond in question. With a true short-duration portfolio, yield moves have a limited impact on bond prices. The income, therefore, is a large component of expected total return.

Some may correctly point out that since the starting point for yields is much lower than what has been experienced in past cycles, this episode may be different. This may warrant a word of caution for short-term government-related strategies that offer minimal yield to provide a cushion from any price declines associated with rising rates.  For example, the current two-year Treasury bond now has a 0.55% yield with 1.95 years of duration (data from Bloomberg, as of December 16, 2014). What happens with a small move in short-term yields? If we take a simple example whereby two-year bond yields rise by 100 basis points (1.0%) over the next 12 months, that rise in yield would lead to a 1.95% decline in the price of the bond (1.95-year duration * 100 basis point move in rates). This would be offset by the income yield of 0.55%. The result is a loss of 1.40%.   While not a disastrous outcome, this certainly is not an enticing scenario either.

A Different Approach to Short Duration
Lord Abbett takes a different approach to investing in the short-duration space. Rather than focusing purely on government-related securities, the Short Duration Income Fund was designed to take advantage of inefficiencies across credit-sensitive sectors of the short-duration market. Sectors such as short-term investment-grade corporate bonds, for example, tend to offer additional yield over Treasuries, and have historically generated higher total returns over time. With the benefit of rigorous credit research, the Fund is diversified across multiple sectors of the market, and can adjust the allocations depending upon the market environment. Given this approach, the Fund has a similar duration to a two-year Treasury bond, while generating much higher income. 

Going through a similar exercise of yield versus duration (assuming all yields move by 100 basis points, and credit spreads remain the same), the higher income generated by credit-sensitive securities would lead to positive total return in the face of rising short-term rates over the next year. Of course there are many simplifying assumptions here, and actual market performance may be quite different.

In addition, one of the benefits of a short-maturity strategy is the constant cash flow that is being returned to reinvest at potentially higher rates. For example, as of November 30, 2014, approximately 22% of the Short Duration Income Fund matures in less than one year. If market rates move higher, these maturing funds will be available to invest at those higher yields.

Summing Up
For much of the past five years, the rising-rates scenario has been more fear than reality. As we enter the new year, it appears that this will be the year in which the Fed will begin to remove its policy of extreme accommodation, and start to raise short-term interest rates. Given the lack of inflation and sluggish growth overseas, the move to higher rates likely will be slow and gradual. Despite a move to higher rates, history suggests that short-term bonds, particularly those that are credit-sensitive, can still generate positive returns. 

Given the uncertainty in the market, a prudent course for fixed-income portfolios may be a diversified approach that includes short-maturity bonds, intermediate-term bonds, high-yield bonds, and floating-rate loans to provide income and total returns even in the face of higher rates.

 

 

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