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Market View

As a potential source of income with limited interest-rate risk and low volatility, ultra-short bond strategies have a role to play in any interest-rate environment.

In a previous Market View, we discussed the difficulty of correctly forecasting the direction of interest rates. As we enter the final quarter of 2017, bond yields are once again proving their unpredictability. As Chart 1 illustrates, after a significant climb during the second half of 2016, 10-year Treasury yields have reversed course over the past six months, reaching a post-election low of 2.05% on September 8.

 

Chart 1. Despite Consensus Expectations for Higher Rates, Yields Have Declined
10-year U.S. Treasury yields (June 30, 2016–September 8, 2017)  

Source: Bloomberg. Performance quoted above is historical. Past performance is no guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett 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.

 

The interest-rate moves of the past few years illustrate the challenges of trying to build a portfolio based on one’s interest-rate forecast. Instead, it may be prudent to build a diversified bond portfolio that potentially can be prepared for any interest-rate environment by complementing investment-grade core bonds with high-yield bonds, short-term corporate bonds, floating-rate loans, and ultra-short bonds. 

In particular, we believe that ultra-short bond strategies deserve consideration to potentially:

  • Reduce the interest-rate risk of a core bond allocation;
  • Mitigate portfolio volatility; and
  • Increase the potential income and return relative to cash or money-market portfolios.

One asset class we focused on in our last review of ultra-short strategies was investment-grade floating-rate notes (FRNs). Not to be confused with below-investment-grade bank loans that are commonly found in most floating-rate funds, FRNs, instead, are investment-grade corporate bonds that have floating-rate coupons, typically based on a spread over a short-term benchmark interest rate, such as the three-month London interbank offered rate (LIBOR). As Chart 2 indicates, floating-rate note coupons (as measured by the average coupon in the Bloomberg Barclays Floating Rate Note Index) have continued to inch higher, despite the decline in long-term yields over the past six months (as of September 8, 2017), following the move in short-term rates. Such floating-rate notes offer an investment-grade asset class that provides the potential for an attractive income stream with little interest-rate sensitivity, and low volatility, as well as the potential to benefit from a continued rise in short-term rates.

In fact, as laid out in Table 1, the Floating Rate Note Index has had only a fraction of the volatility of the Bloomberg Barclays Aggregate Index over the past five years. And if we focus on the FRNs with short final maturities (for example, the component of the index with final maturities of less than 18 months), we see even greater stability.

 

Chart 2. Floating-Rate Note Coupons Have Continued to Tick Higher Amid Falling Long-Term Yields
Bloomberg Barclays U.S. Floating Rate Note Index, average coupon versus three-month LIBOR (September 30, 2015–September 8, 2017)

Source: Bloomberg Barclays Indices (Floating Rate Note Index), Bloomberg (three-month LIBOR). Performance quoted above is historical. Past performance is not a reliable indicator or guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett 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.

 

Table 1. Floating Rate Notes Have Offered Limited Interest-Rate Risk and Low Volatility
Data as of August 31, 2017

Source: Barclays and Zephyr. Performance quoted above is historical. Past performance is not a reliable indicator or guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett 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.

 

Summary
We believe that core bonds play an important role in a diversified bond allocation. That said, the evolution of the Bloomberg Barclays U.S. Aggregate Bond Index (“Barclays Aggregate Index”)—the traditional core bond benchmark—has given some investors reason to pause. As shown in Chart 3, over the past decade, as of August 31, 2017, the average duration of the index has increased by approximately 50%, to its recent level of nearly 6.0 years. Meanwhile, the index yield has been cut roughly in half. So, not only does the benchmark offer less income but also less of a yield cushion to offset the negative price return that typically would occur during a rising rate environment. In short, the risk/reward trade-off of the Barclays Aggregate Index has changed.

 

Chart 3. As the Average Duration of Core Bonds Has Increased, Yield Has Declined
Bloomberg Barclays U.S. Aggregate Bond Index, as of August 31, 2017

Source: Bloomberg Barclays Indices. Duration as represented by modified adjusted duration in years. Yield as represented by yield to maturity. Performance quoted above is historical. Past performance is not a reliable indicator or guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett 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.

 

Regardless of when a sustained upward move in interest rates materializes, the inclusion of an ultra-short bond strategy may represent a long-term, strategic complement to core-bond allocations.

 

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