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Market View

Ultra-short bond strategies may provide additional income and total return potential with little additional volatility.

Read time: 3 minutes

Amid the historic volatility the markets experienced in March, there were some unusual price movements in the short-term credit markets. At the time, we tried to reassure investors that much of the price action was not an indication of significant credit issues but rather was being driven by supply/demand imbalances in short-term lending markets.

Uncertainty regarding the impact of COVID-19 prompted many companies to build additional liquidity in March in order to have a war chest of cash on their balance sheets. As they went to borrow through commercial paper and other markets, traditional buyers of short-term securities took a step back from those markets to build their own cash reserves. These imbalances created sharp spikes in credit spreads, resulting in lower prices and higher yields even for very short-term, investment-grade securities.

Additional Yield and Return Potential

As markets have calmed down and the U.S. Federal Reserve has intervened with multiple programs to supply adequate liquidity to ensure that markets function properly, yields and spreads have receded, but still remain elevated relative to pre-COVID crisis levels. We recently wrote about how this has played out in the short-term corporate bond market. This has also created interesting opportunities in the ultra-short bond markets.

The accompanying exhibits illustrate yields on select asset classes which are often included in ultra-short strategies (such as short-term investment-grade corporate bonds, commercial paper, and asset-backed securities) relative to three-month U.S. Treasury bills. Historically, these sectors have offered modest spread over Treasury bills with limited duration and credit risk, providing an option for additional yield and return potential over cash and money market securities, with lower volatility than short- or intermediate-term bond strategies.

 

Figure 1. Ultra Short Bonds Have Been Offering Unusually High Excess Yield with Limited Credit Risk

Source: Bloomberg Barclays & ICE Data Indices, LLC. Data from April 1, 2014-April 30, 2020. 1Bloomberg Barclays USFRN <18mos. 2Bloomberg Barclays 3 Month U.S. T-Bill Index. 3ICE BofA ABS 0-3 yr Fixed Rate.
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.

 

Figure 1 shows how yields spiked amid the grab for liquidity in March and have since partially recovered. However, yields on alternative so-called “risk-free” options, such as Treasury bills, have collapsed to nearly 0% (and briefly dipped into negative territory). Relative to Treasury bills and cash, short-maturity investment-grade bonds recently offered unusually high spreads with very low duration and little credit risk.

Low Historical Default Rates

Historical default rates for short-maturity investment-grade bonds have been extremely low, as Figure 2 makes clear.

 

Figure 2. Historically, Default Rates for Short-Maturity Investment-Grade Bonds Have Been Extremely Low.

Sources: Moody’s, Standard & Poor’s. *Default rate on “AA”-rated ABS was 0% every year except 2002. Data provided in the charts above are latest available data. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

The recent experience illustrates one of the characteristics of short-term investment-grade credit; during periods of extreme moves in credit spreads or interest rates, such securities can experience some price volatility. (There is no question March was a period of extreme volatility; high-yield spreads increased by 750 basis points [bps] off January lows, while spreads on short-term “BBB”-rated bonds rose by almost 500 bps. In such an environment one would expect some price declines, even in very short-term investment-grade securities.) However, if you have true short-maturity bonds, and can avoid credit issues, prices ultimately recover as there is a “pull to par” as these securities approach their maturity date.

Going Forward

During the recent period of volatility, there was a large flight to safety: over $1 trillion in assets have flocked to U.S. government money market funds since mid-February, with total assets now approaching $4 trillion. With the drop in Treasury bill yields, that large pile of assets is now yielding close to 0%.

For many investors, a portion of that “cash” needs to be in true cash despite the lack of yield for short-term liquidity needs and unexpected expenses. But there may be a portion of that cash that is not likely to be needed in the near term—say, for at least three months or more—that can take advantage of the unusual spread opportunity in ultra-short bonds.

We believe that the recent market environment is creating attractive long-term opportunities in certain segments of the equity and credit markets. For investors who are holding excess cash on the sidelines before committing funds to these markets, they may want to consider allocating a portion of their “long- term cash” to short- and ultra-short bond strategies that can provide additional income and total return potential with little additional volatility.

 

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds.

No investing strategy can overcome all market volatility or guarantee future results.

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.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Glossary of Terms

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

basis point is one one-hundredth of a percentage point.

Pull to Par is the effect in which the price of a bond converges to par (or face value) as the bond approaches maturity.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point).

The Bloomberg Barclays Capital US FRN < 18 months Index is a subset of the US Floating-Rate Note (FRN) Index, which measures the performance of USD denominated, investment-grade, floating-rate notes across corporate and government-related sectors. 

The Bloomberg Barclays 1-3 Month U.S. Treasury Bill Index measures the performance of public obligations of the U.S. Treasury that have a remaining maturity of greater than or equal to 1 month and less than 3 months.

The ICE BofA/Merrill Lynch ABS Fixed Rate 0-3 Year Index, is a rate- and maturity-specific subset of the ICE BofA/ML U.S. Fixed and Floating Rate Asset Backed Securities Index

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

ICE BofAML Index Information:

Source ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofAML INDICES AND RELATED DATA ON AN “AS IS” BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofAML INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD ABBETT, OR ANY OF ITS PRODUCTS OR SERVICES.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The credit quality of the securities are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principle on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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