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Market View

As U.S. Treasury yields have moved higher in the past few months, how have short-maturity fixed-income securities held up?

 

In Brief

  • A sharp increase in U.S. Treasury yields has led to negative returns in many parts of U.S. fixed income, with longer-duration assets generally faring the worst.
  • Short-maturity segments, however, have posted flat to modestly positive returns year to date through May 31, even as the broader bond market has suffered.
  • Taking a longer view, short-maturity credit sectors have had much lower volatility, and much higher risk-adjusted returns, than the broad bond market over the past three- and five-year periods through May 31, despite a sharp rise in short-term interest rates.
  • Today’s higher yields on short-duration credit (e.g., short-term investment-grade corporate bonds) give investors a more attractive starting point, offering the potential for higher income and returns over time.

 

Since we published a February 2018 commentary on short-duration securities and rising interest rates, yields on two- and 10-year U.S. Treasury notes have continued to climb. As Chart 1 shows, the yields are higher year to date (through May 31), and sharply above their July 2016 lows. As a result, many segments of the bond market are down, especially those characterized by higher duration.

 

Chart 1. Yields on Two- and 10-Year U.S. Treasuries Have Increased Sharply in Recent Years
Yields for the period May 31, 2013-May 31, 2018

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. Past performance is not a reliable indicator or guarantee of future results. Indexes are unmanaged  and are not available for direct investment. Due to market volatility, the market may not perform in a similar manner in the future.  

 

Rising rates have posed challenges for much of the bond market in 2018. The Bloomberg Barclays U.S. Aggregate Bond Index (a broad measure of U.S. bond market performance) posted a negative return of 1.5% year to date through May 31. In fact, the Aggregate Index has also generated negative returns over the trailing one-year period, and since the recent low in the 10-year U.S. Treasury yield in July 2016.  (Note that the Bloomberg Barclays Aggregate has a heavy weight in U.S. Treasuries and government-related securities.) Meanwhile, short-maturity credit segments of the bond market have held up well since the low in Treasury yields reached in July 2016, registering positive returns over these same time periods.

 

Table 1. Short-Term Credit Has Held Up Well in 2018 Compared to the Broad Bond Market
Total return (%)  for indicated indexes, as of May 31, 2018

Source: Morningstar. Short-term U.S. Treasuries represented by the ICE BofA Merrill Lynch 1-3 Year U.S. Treasury Index. Short-term corporate bonds represented by the ICE BofA Merrill Lynch 1-3 Year U.S. Corporate Index. Short-term BBB-rated corporates represented by the ICE BofA Merrill Lynch 1-3 Year BBB U.S. Corporate Index. Short-term CMBS represented by the Bloomberg Barclays U.S. 1-3.5 Year CMBS Investment Grade Index. Short-term ABS represented by the ICE BofA Merrill Lynch U.S. 0-3 Year ABS Index. Short-term high yield bonds represented by the Bloomberg Barclays U.S. 1-3 Year High Yield Bond Index. “Bloomberg Barclays Aggregate” refers to 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 and are not available for direct investment. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk.

 

The Potential Benefits of Short Duration
Remember, 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 not significant due to the low duration of short-maturity bonds, the income generated becomes the crucial component of total return.  [Of course, investors can lose principal when investing in short term securities.]  So, as short rates rise, the modest price declines are often more than offset by the income, leading to positive total return. Chart 2 provides an update as to how this has played out for short-maturity bonds in the recent interest-rate environment, in terms of total return, volatility (as measured by standard deviation), and risk-adjusted return (as measured by the Sharpe ratio). [Note: In general, the bond market is volatile, and fixed-income securities carry interest-rate risk. As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.]

 

Chart 2. Short Credit Historically Has Generated Higher Risk-Adjusted Returns than Core Bonds and Treasuries
Return and standard deviation for the three years ended May 31, 2018 (chart); return, standard deviation (volatility), and Sharpe ratio for indicated periods (table)

 

Source: Morningstar. Short-term U.S. Treasuries represented by the ICE BofA Merrill Lynch 1-3 Year U.S. Treasury Index. Short-term corporate bonds represented by the ICE BofA Merrill Lynch 1-3 Year U.S. Corporate Index. Short-term BBB-rated corporates represented by the ICE BofA Merrill Lynch 1-3 Year BBB U.S. Corporate Index. Short-term CMBS represented by the Bloomberg Barclays U.S. 1-3.5 Year CMBS Investment Grade Index. Short-term ABS represented by the ICE BofA Merrill Lynch U.S. 0-3 Year ABS Index. Short-term high yield bonds represented by the Bloomberg Barclays U.S. 1-3 Year High Yield Bond Index. “Bloomberg Barclays Aggregate” refers to the Bloomberg Barclays U.S. Aggregate Bond Index.

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 and are not available for direct investment. Past performance is not a reliable indicator or a guarantee of future results.

 

The table that accompanies Chart 2 shows that short-term U.S. Treasuries (as measured by the ICE BofAML 1-3 Year U.S. Treasury Index) barely eked out a positive showing in the three- and five-year periods through May 31, 2018.  While this index has had low volatility, with the two-year Treasury starting with a yield of less than 30 basis points (bps) five years ago, there was very little yield in short-term Treasuries to offset the negative impact of rising yields.

What happened in the more credit-sensitive short-term sectors? Short-term investment-grade corporate bonds and commercial mortgage-backed securities, 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 likely will be starting at a higher initial yield, creating the potential for higher income and total return in the future.  Chart 3 provides one telling example of how this might work: the average yield to maturity of 3.10% on the ICE BofAML1-3 Year Corporate Bond Index is more than 200 bps higher than the low point in yield, in early 2014, of just less than 1.0%. Thus, new money put to work in the asset class is in a better position to generate higher returns going forward due to that higher starting yield today.

 

Chart 3. Short-Term Corporate Yields Have Increased Nearly 200 Basis Points Since 2014 Lows
Average yield to maturity, ICE BofA Merrill Lynch 1-3 Year Corporate Bond Index, May 31, 2013–May 31, 2018

Source: Bloomberg.

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. Indexes are unmanaged and are not available for direct investment.

 

One other point to consider is that even as forecasters confidently express their views on where yields might be headed next, actual rate movements remain unpredictable. Witness the recent pullback in yields on fears that Italian political turmoil may disrupt eurozone economic and currency regimes. The relative stability of short credit, given recent volatility in equity markets and bond-yield spreads, may prove appealing to investors looking for diversification in their fixed-income portfolios.

Summing Up
With the large move in yields in recent months leading to negative returns in the Bloomberg Barclays Aggregate Index, investors once again may be reconsidering their core bond allocations.  Short-maturity credit sectors historically 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. [Note: There can be no assurance that the short-term credit market will continue to experience such performance in the future.]

 

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