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Market View

In a difficult year to generate returns in bonds, or many other asset classes for that matter, short-term corporate bonds were able to hold up relatively well.  

For much of 2015, investors were focused on anticipating the actions of the U.S. Federal Reserve (Fed).  In fact, ever since former Fed chairman Ben Bernanke first mentioned the idea of tapering asset purchases back in May 2013, the markets have been waiting for the Fed to begin raising the fed funds target rate.  They finally witnessed that first move, with a 25 basis-point increase on December 16, 2015. 

With the date of “liftoff” now behind us, the Fed is likely to be the center of attention once again as investors fret over the pace and magnitude of subsequent rate hikes in 2016. Inevitably, the words of current Fed chairwoman Janet Yellen and her colleagues will be parsed in an attempt to anticipate future Fed actions.

It is important to realize, however, that many parts of the bond market have already been adjusting to a world of higher interest rates, especially for shorter maturities. While the yield on the 10-year U.S. Treasury bond (2.30% as of December 30, 2015) is currently about 70 basis points (bps) higher than where it traded before the "taper tantrum" of 2013, it has been trading in a fairly narrow range over the past six months. 

But, as the accompanying charts illustrate, there have been more dramatic moves in other segments of the market. The two-year Treasury note, for example, traded at a yield of 1.10% on December 30, the highest level in five years, and 90 bps higher than the lows of May 2013.

 

Chart 1. Bonds Are Anticipating a World of Higher Interest Rates
Yields on select fixed-income asset classes, April 30, 2013–December 31, 2015

Source: Morningstar Direct.
Short-term corporate bonds are represented by the BofA Merrill Lynch 1-3 Year U.S. Corporate Index. High-yield bonds are represented by the BofA Merrill Lynch U.S. High Yield Master II Index.
Asset classes selected are intended to be representative of the broad bond market.  Other asset classes may have performed differently.
Past performance is no guarantee of future results. 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 and expenses, and are not available for direct investment. Due to market volatility, the market may not perform in a similar manner in the future.

 

The moves in credit have been even more extreme. With sharply wider credit spreads on high-yield bonds over the past 18 months, primarily due to stress among commodity-related sectors of the market, the average yield in the Merrill Lynch U.S. High Yield Constrained Index hit a peak of 9.07%, before settling in at 8.80% at year-end, nearly 400 bps above the lows of mid-2014. In short-term corporate bonds, the combination of the 90 basis-point move in the two-year Treasury and wider credit spreads resulted in a 147 basis-point yield move in the Merrill Lynch 1-3 year BBB-rated US Corporate Index from the lows of 2014. 

Despite these dramatic moves in yields, short-term corporate bonds still generated positive returns in 2015. Although these returns can be described as modest at best, they came in an environment of higher Treasury yields, wider credit spreads, and negative returns in many other parts of fixed income. 

 

Table 1. Short-Term Corporates Generated Positive Returns in 2015

Source: Morningstar Direct.

 

How can this be the case? The first factor is simply one of the basics of having a low duration. With a true short-duration strategy, big changes in yields have only a modest impact on prices relative to longer-duration strategies. The second factor to consider is that the change in price is just one component of total returnWhile higher yields lead to lower prices on securities, the income generated from bonds historically has been the primary driver of the total return on investment. 

In a difficult year to generate returns in bonds, or many other asset classes for that matter, short-term corporate bonds were able to hold up relatively well. This should not come as a surprise. As we have pointed out in the past, short-term corporate bonds have consistently generated positive returns, even during periods of rising long-term interest rates, and during periods of rising short-term interest rates. And given their low duration, short-term corporate bonds tend to be less volatile than longer-duration bonds, particularly during times of market stress.

What about the months to come? In addition to having limited interest-rate sensitivity, short-duration strategies have the benefit of consistent cash flow from bond maturities as well as coupon payments that can be reinvested at today’s prevailing higher yields. That sets up the opportunity for higher yields and the potential for higher returns going forward. 

Predicting the direction of interest rates has proven to be a very difficult exercise, but a slow, gradual adjustment higher in interest rates seems to be the consensus view for 2016. The U.S. economy appears to be on a continued course of positive, but less than robust, economic growth. Given their long track record of positive returns with limited volatility, the higher yields available on short-term corporate bonds today make them an attractive alternative as we enter 2016. 

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

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