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Market View

Short-term securities such as corporate bonds, ABS, and CMBS, recently offered yields near multi-year highs, with lower volatility than core bonds.

 

In Brief

  • While many investment categories posted flat or negative returns in 2018, U.S. short-term credit securities posted positive  performance.
  • Despite the headwind of rising short-term rates over the past three years, short duration credit sectors have delivered more attractive risk-adjusted returns than intermediate core bond holdings.
  • With the much higher yields now available on short duration credit, and with investors apparently being undercompensated for taking on duration risk, we think short credit merits a closer look from investors.

 

In an overall difficult year for financial markets, the broad U.S. high-yield bond, U.S. investment-grade corporate bond, and global equity markets all suffered losses in 2018. The U.S. bond-market benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index (Aggregate Index), with a large weight in U.S. Treasury and government-related securities, needed a strong rally amid the flight to quality in the fourth quarter just to end 2018 flat on the year. There were, however, a few areas that generated positive returns (see Chart 1).

 

Chart 1. 2018 Was a Challenging Year for Many Fixed-Income and Equity Investments
Total return for indicated indexes in 2018

Source: Morningstar. Data as of December 31, 2018. Short-Term ABS (asset-backed securities)=ICE BofAML U.S. 0-3 Year ABS Index. Short-Term CMBS (commercial mortgage-backed securities)=Bloomberg Barclays U.S. Non-Agency Investment Grade 1-3.5 Year CMBS Index. Short-Term Corporates=ICE BofAML 1-3 Year U.S. Corporate Index. CS Loan Index=Credit Suisse Leveraged Loan Index. Bloomberg Barclays Aggregate=Bloomberg Barclays U.S. Aggregate Bond Index. High Yield= ICE BofAML U.S. High Yield Constrained Index. IG (investment-grade) Corporate= ICE BofAML U.S. Corporate Index. S&P 500=S&P 500® Index. Mid Cap Equity= Russell Midcap® Index. Small Cap Equity=Russell 2000® Index. International Equity=MSCI ACWI Index.
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.  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.

 

We recently highlighted a below-investment grade credit sector, floating-rate bank loans, that had a positive return in 2018. Here, we focus on another: short duration investment-grade credit (including short-term investment grade corporate bonds, commercial mortgage backed securities [CMBS], and asset-backed securities [ABS]).

 

The Recent Environment
On the surface, the market environment in 2018 appeared unfavorable for short-term credit. The U.S. Federal Reserve’s (Fed) moves to normalize monetary policy prompted a large increase in short-term interest rates, leading to a flattening of the yield curve (see Chart 2).

 

Chart 2. The Yield Curve Has Flattened Dramatically in Recent Years
U.S. Treasury yield curve for indicated dates

Source: Bloomberg.

 

The target fed funds rate and the yield on the two-year U.S. Treasury note have both increased by approximately 225 basis points (bps). In 2018 alone, the Fed raised rates by 100 basis points, and the two-year Treasury yield rose by 61 bps.

As a further headwind, the corporate bond markets experienced significant spread widening amid fears of slowing global growth, declining oil prices, and uncertainty surrounding Fed policy and U.S.-China trade negotiations. Investment-grade corporate spreads widened by 60 bps, while high-yield spreads jumped by 170 bps during the year.

Despite this backdrop, short duration credit sectors were able to generate positive returns in 2018, and outperform longer duration, “higher quality” asset classes such as U.S. Treasuries and the Aggregate Index.  In fact, going back over the trailing three years, short duration corporate bonds have generated higher returns, with much lower volatility, than the Aggregate Index, translating to much higher risk-adjusted returns (see Table 1).

 

Table 1. Short-Term Corporate Bonds Have Provided Attractive Risk-Adjusted Returns in Recent Years
Total return, volatility (standard deviation), and Sharpe ratio

Source: Morningstar Direct. Short-Term Corporate Bonds=ICE BofAML 1-3 Year BBB U.S. Corporate Index. Barclays Aggregate Index=Bloomberg Barclays U.S. Aggregate Bond Index.
Past performance is not a reliable indicator or guarantee of future results. Performance during other periods may have been different. Other indexes may not have performed in the same manner under similar conditions. 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.

 

How has short-term credit delivered such results during this period of volatility in credit and rates? This is one of the key traits of true short-maturity bonds. During periods of large moves in rates or spreads, the prices of short-term bonds can come under pressure over short periods. But barring any major changes in their credit standing, bonds will ultimately mature at par value. So, if a bond is due to mature in a year or two, price declines are typically limited. The “pull to par” of short maturity investment grade bonds limits volatility. As you extend your holding period, the likelihood of negative returns diminishes. In fact, a review of calendar year returns dating back to the index inception, the ICE BofAML 1-3 Year Corporate Bond Index has had positive returns in 41 of the past 42 years. (The one negative year, a relatively modest decline of -2.78% in 2008, was followed by a strong recovery of 14.7% in 2009.)

Going Forward
During the past three years, short duration credit has delivered more attractive risk-adjusted returns than intermediate-term core bonds. Given the upward move in interest rates, short credit may be set up for an even better opportunity going forward.

Take a look at Chart 4. First, with the large move in short-term interest rates, the starting yield on short duration credit instruments is much higher today than it has been in recent years. For example, the average yield in the ICE BofAML 1-3 Year U.S. Corporate Index rose to 3.5% as of 2018 year-end, compared to a low of just under 1.0% five years ago.  Starting yield is a good indicator of future returns for short-term bonds, so investing at today’s higher yields may give investors a head start in terms of future income returns versus what was available one, three, or five years ago.
 

Chart 4. Today’s Higher Short-Term Rates May Offer Income Investors a Leg Up in 2019
Yields on indicated indexes, December 31, 2013–December 31, 2018

Source: Bloomberg. Short-term corporate bonds represented by the ICE BofAML 1-3 Year BBB U.S. Corporate Index. Short-term commercial mortgage-backed securities (CMBS) represented by the Bloomberg Barclays Non-Agency Investment Grade 1-3.5 Year CMBS Index. Short-term asset-backed securities (ABS) represented by the ICE BofAML U.S. 0-3 Year ABS Index.
Past performance is not a reliable indicator or guarantee of future results. Due to market volatility, the market may not perform in a similar manner in the future. Other time periods may have been different. The historical data are for illustrative purposes only and do not represent the performance of any portfolio managed by Lord Abbett or any particular investment.

 

Second, given the tremendous flattening of the yield curve mentioned above, short duration credit provides a much more attractive reward for risk relative to extending duration. For example, the slope of the yield curve between the 10-year and 2-year U.S. Treasury notes had shrunk to a mere 16 basis points as of December 31, 2018.  As the yield curve has flattened and term premiums have declined, investors are not being compensated for the duration risk in traditional intermediate-term core bond holdings. With these shifts, short-term credit sectors such as investment-grade corporate bonds, CMBS, and ABS offer similar to higher yields than the Aggregate Index, but with one-third of the duration exposure, based on Bloomberg data.   

While history has shown that trying to forecast the direction of interest rates can be a fool’s errand, market expectations suggest that the pace of Fed rate hikes will slow. Fed funds futures pricing as of January 25 suggests a high likelihood that the Fed will remain on hold for 2019, or perhaps have one additional hike. If that holds true, short duration assets likely would avoid a key headwind from previous years.

Summing Up
In the past, we have written about the anomaly in short duration credit sectors: investors have historically been over-compensated for credit exposure with additional yield. We have suggested that investors may want to consider short duration credit strategies as a complement to, or replacement for, a portion of their core bond allocation.

In the face of what should have been a very difficult environment over the past few years, short duration credit has been able to provide attractive risk-adjusted returns relative to intermediate-term core bonds. With the much higher yields now available on short duration credit, and the lack of compensation for taking on duration, investors may want to take a fresh look at short duration credit strategies.

 

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