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Market View

An allocation to short-term corporate bonds can complement a traditional core bond strategy by potentially reducing volatility, while maintaining an attractive yield.

 

In Brief

  • With key categories of U.S. fixed-income securities featuring high interest-rate sensitivity and low yield, investors may be rethinking their approach to a core bond allocation.
  • Investors may be able to reduce the interest-rate sensitivity of their traditional core bond allocation, without sacrificing yield, through the use of short-term credit.
  • U.S. short-term corporate bonds have provided a more attractive risk-adjusted return experience relative to the Bloomberg Barclays U.S. Aggregate Bond Index (Aggregate Index) over the last three-, five-, and 10-year periods.
  • Over a three-year period, an equal blend of the Aggregate Index and short-term corporates1 historically has produced greater return and less risk than the Aggregate Index alone.

 

Chart 1. Recent Experience May Prompt Investors to Reexamine Their Approach to Core Bonds
Total return and standard deviation for indicated indexes, February 1, 2015–January 31, 2018

Source: Morningstar. “50/50 Blend Agg/BBB Corp” refers to an equal-weighted blend of the Bloomberg Barclays U.S. Aggregate Bond Index and the ICE BofAML 1-3 Year BBB U.S. Corporate Index.
Past performance is not a reliable indicator or a guarantee of future results. The historical data shown in the chart are for illustrative purposes only and do 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.

 

Most core bond strategies are benchmarked against the Bloomberg Barclays U.S. Aggregate Bond Index (the “Aggregate Index”), which has significant exposure to Treasuries and other securities (see Chart 2) that today offer high interest rate sensitivity and low yields.

 

Chart 2. Know Your Aggregate
Composition and characteristics of the Bloomberg Barclays U.S. Aggregate Bond Index, as of January 31, 2018

Source: Bloomberg Barclays Indices.
1“Other” refers to sovereign, supranational, and local authorities. 2Represents modified adjusted duration of the Bloomberg Barclays U.S. Aggregate Bond Index.3Represents yield to maturity of the  Bloomberg Barclays U.S. Aggregate Bond Index.
Past performance is not a reliable indicator or 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 or expenses, and are not available for direct investment.

 

Although the traditional core bond strategy plays an important role over time as an equity diversifier—one that historically has zigged when the stock market has zagged—today’s environment certainly warrants a fresh look at this approach.

The Aggregate Index was down roughly 1% from January 26–February 8, 2018—a period when stocks (as represented by the S&P 500® Index) experienced a 10% correction. The reason?  An increase in inflation expectations, which led to fears that the Fed may have to raise rates faster than expected. Admittedly, this was a time period too short to be considered a trend, but as discussed, core bonds are expected to deliver positive returns when equities falter.

How might investors be able to reduce the level of interest-rate sensitivity in a fixed-income allocation without sacrificing yield? Short-maturity corporates may hold the key. The representative ICE BofAML 1-3 Year U.S. Corporate Index recently featured a duration of roughly 1.8 years, with a yield of nearly 2.8%, comparable to the nearly 3% yield of the Aggregate Index. For short-term corporates, a robust coupon return—sitting higher than its duration—historically has offset any negative price return associated with higher rates and, ultimately, led to positive returns in each calendar year that the Fed has raised rates since 1978. Furthermore, the asset class has provided a more attractive risk-adjusted return experience relative to the Aggregate Index over the last three-, five-, and 10-year periods.  Short corporates also outperformed the Aggregate Index during the recent episode of market volatility in February.

If now we look back at Chart 1, we see that over the past three years, short-term corporates have delivered higher returns, with significantly less risk (as measured by standard deviation), than the Aggregate Index, and a very compelling Sharpe ratio. For those not looking to divest all of their traditional core exposure, an equal blend of the Aggregate Index and short-term corporates has produced greater return and less risk than the Aggregate Index on its own.1 This consistent risk/return profile suggests that short-term credit portfolios may not just be a “go to” hedge against higher interest rates but also an integral part of an overall fixed-income allocation as well as an effective complement to a traditional core strategy.

Conclusion
For those concerned about the interest-rate sensitivity of their current core bond portfolio, complementing that allocation with a short-term credit allocation may make sense.  Short-term, credit-sensitive bonds historically have offered comparable yields to intermediate-term government bonds, and with lower duration. What is more, their short maturity profile may offer investors the opportunity to capitalize on rising rates by reinvesting the proceeds on maturing bonds into new securities with higher coupons.

 

1As represented by a 50/50 blend of the Bloomberg Barclays U.S. Aggregate Bond Index and the ICE BofAML 1-3 Year BBB U.S. Corporate Index for the three-year period ended January 31, 2018.

 

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