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Market View

Short duration fixed-income securities have outperformed other types of bonds even as the Treasury curve has flattened amid a continued rise in short- and long-term interest rates.

 

In Brief

  • Investors have expressed concerns about the impact of rising short-term rates and a flattening yield curve on the performance of short-duration fixed-income securities.
  • In fact, the asset class has weathered the rising-rate environment of the past few years quite well, posting positive performance and outperforming high quality core bond categories.
  • Further, the higher rates now available on short-duration bonds may put these securities in a better position to generate higher returns going forward.


Previous Market Views have highlighted the opportunities in short duration credit sectors (such as short-term investment-grade corporate bonds, asset-backed securities and commercial mortgage-backed securities), including its potential to offer a source of income with low interest-rate sensitivity and low volatility—and its role as a complement to, or a replacement for, a portion of an investor’s core bond allocation. One common question we have received in recent years centers around the impact of rising interest rates on the asset class. In particular, investors have been concerned that rate hikes by the U.S. Federal Reserve (Fed) will cause the yield curve to flatten, leading to negative performance for shorter-dated securities.

But that is exactly what has been happening in recent years—and short credit has weathered the period of rising rates quite well. With the third quarter of 2018 in the books, let’s review some important developments for the asset class, including its performance relative to other types of investment-grade bonds over the past several years.

1) Short-term rates have moved up by a substantial amount. Two-year U.S. Treasury yields ended September 2018 at 2.82%, some 260 basis points (bps) higher than their low point five years ago (see Chart 1), as the Fed has raised rates eight times since December 2015. More recently, this move higher has accelerated, as the market is pricing in a greater probability of continued rate hikes in the coming years.

2) The yield curve has flattened. Yields on 10-year U.S. Treasury bonds also have moved higher to settle above 3.0%—about 170 bps above the low reached in July 2016. As a result of these moves, the yield curve has flattened quite a bit, with the gap between the 10-year and two-year yields now a mere 24 bps (see Chart 1).

 

Chart 1. Getting Flatter: Fed Hikes Have Led to a Narrower Gap between Long- and Short-Term Rates
Yields on two-year and 10-year U.S. Treasury notes, March 1, 2013–September 30, 2018

Source: Bloomberg.
 

In such an environment, many would have expected short duration credit to underperform. But as we shall see, those expectations have proven incorrect.

3) Short credit has outperformed other fixed-income investments. As of September 30, 2018, short maturity credit sectors (including investment-grade corporates, ABS, and CMBS) have all generated positive returns over the year-to-date, and one- and three-year periods, outperforming short-term Treasuries, long-term Treasuries, and the broader Bloomberg Barclays U.S. Aggregate Bond Index (Aggregate Index).

 

Table 1. Short Credit Has Outperformed in Recent Years

Source: Morningstar. “Aggregate Bond Index” refers to the Bloomberg Barclays U.S. Aggregate Bond Index. Two- and 10-year U.S. Treasury securities represented by the ICE BofAML 2-Year U.S. Treasury Index and the ICE BofAML 10-Year U.S. Treasury Index, respectively.  Short-term corporate bonds represented by the ICE BofAML 1-3 Year U.S. Corporate Index. Short-term BBB-rated 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 U.S. 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. 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.

 

But the story doesn’t end there. What is truly eye-catching is the performance of short credit versus the Aggregate Index from the bottom in 10-year Treasury rates on July 6, 2016.

Chart 2. Short Credit Has Outpaced the Aggregate Index in the Face of Rising Rates
Index levels (based on starting level of 100), July 6, 2016–September 30, 2018

Source: Morningstar. Chart data lines terminate at September 30, 2018. “Aggregate Bond Index” refers to the Bloomberg Barclays U.S. Aggregate Bond Index. Short-term BBB-rated corporate bonds represented by the ICE BofA Merrill Lynch 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 BofA Merrill Lynch U.S. 0-3 Year ABS 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.

 

4) Yields are much higher today. Investing at today’s higher yields may give investors a “head start” in terms of future income, making now an even more attractive entry point for short-maturity credit securities (see Chart 3). Indeed, we believe that one of the best predictors of future returns for short-term bonds is the starting yield. 

 

Chart 3. Today’s Higher Short-Term Rates May Present an Attractive “Starting Line” for Investors
Yields on indicated indexes, September 30, 2013–September 30, 2018

Source: Bloomberg. Short-term corporate bonds represented by the ICE BofAML 1-3 Year 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.

 

Summing Up
The performance data above focuses on investment-grade asset classes. Lower-rated sectors such as high-yield bonds and floating rate bank loans have generated even stronger returns over this period. But within investment grade, 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. Thus, new money put to work in the asset class may be in a better position to generate higher returns going forward due to that higher starting yield today. [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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