Why Short Duration Now
Why Short Duration Now
Members of the Janus Henderson Global Bonds Team explain why the return of positive real interest rates comes at a welcome time.
For much of the post-financial-crisis era, fixed income investors have had to make do without a key component of their tool kit: attractively yielding short-duration bonds. The culprit was the highly accommodative monetary policy undertaken by global central banks. Large-scale asset purchases pushed real interest rates into negative territory and forced yield-starved investors farther out along the risk spectrum. At long last, the end of this period is in sight as real rates on short-term securities have once again turned positive. This development has elevated the attractiveness of short-term bonds, especially when compared to those of longer tenors. Investors preferring liquid instruments that provide higher yields than cash and those seeking to complement core bond portfolios stand to benefit. A return to positive real yields comes not a moment too soon as the forces that had suppressed volatility – a development that seemingly gave investors the green light to hold riskier assets – seem set to reverse, thus increasing the odds of more turbulent markets.
- For the first time since the Global Financial Crisis, real yields on shorter-dated Treasuries have turned positive.
- Fixed income investors seeking higher liquidity or a more conservative risk profile can now maintain shorter duration with considerably less risk of incurring negative returns.
- This development comes just in time, as longer-dated fixed income securities are largely failing to compensate investors for their near record-high interest-rate risk.
The “Extraordinary” Background
In the wake of the Global Financial Crisis, many of the world’s major central banks injected massive amounts of liquidity into financial markets and became aggressive purchasers of a wide range of fixed income instruments – and in some cases other asset classes. The scale in which central banks were willing to expand balance sheets resulted in them becoming the marginal buyer of government debt, and in the process, sending yields on shorter-dated – and in some cases, longer-tenored – securities into negative territory. Sub-zero returns along the front end of the yield curve took away a traditional liquid source of income from investors and forced them into riskier asset classes in order to generate sufficient carry, or yield above cash. Common destinations included longer-dated government debt, high-yield corporate credit, emerging market debt and even equities.
Generic 2-year Sovereign Notes
Source: Bloomberg, as of 6/30/18.
In more recent years, many investors sought to generate income by taking on more esoteric exposure, including selling volatility – a strategy aimed to benefit from subdued market swings in bonds as well as other asset classes. The pervasiveness of this strategy resulted in suppressed volatility across markets and created a level of complacency as investors deduced that the historical risk profiles of high-yield credit, emerging markets and stocks were not to be feared.
2016: The Pivotal Year
For many years, low real yields reflected, in part, sluggish global economic growth and the distortive effects of central bank asset purchases. That changed in the wake of the 2016 U.S. election. Risk assets rallied and Treasuries sold off as investors priced in the prospect of a pro-growth agenda from the incoming Trump administration. The exit from safer securities was further propelled by a distinct shift in monetary policy. Investors forecasted that, after years of failing to meet its own projections, the Federal Reserve (Fed) would raise the benchmark overnight lending rate multiple times in 2017. The expectation of higher rates nudged yields among shorter- and intermediate-dated Treasuries into a higher band than what had existed during the preceding years. Yields on longer-dated Treasuries proved stickier as their relative value stacked up well against foreign alternatives and domestic inflation remained muted.
Where Are We Now?
The Fed indeed altered its rate path, hiking three times in 2017 and twice so far this year. This has pushed the yield on 2-year Treasuries up roughly 200 basis points (bps) over the past two years, to over 2.50%. Inflation – after a 2017 soft patch – has resumed an upward trajectory as well, but at a slower rate than that of shorter-dated bonds. The Fed’s preferred gauge of core inflation1 has risen from 1.3% year-over-year to 1.8%. That is the same level that TIPS Breakevens2 infer inflation will average over the next two years. The result has been real yields on 2-year Treasuries turning positive in late 2017 for the first time in eight years. Consequently, investors have less incentive to venture into riskier asset classes to generate income.
Real Yields on 2-year Treasuries Turn Positive
Source: Bloomberg, as of 6/30/18.
Just in Time
The return of positive carry on the short end of the yield curve goes hand-in-hand with the rising likelihood of higher volatility across a range of asset classes. Both short-term bonds and selling volatility are sources of carry, and as the former starts to offer attractive yields, the impetus to sell volatility will likely diminish. With that dampener on market gyrations weakened, one can expect volatility across a range of asset classes to reset to higher levels.
By many measures, longer-dated Treasuries, high-yield corporates and emerging market debt are richly valued. Should volatility return to historical levels, current valuations may not be sufficient to adequately compensate investors for the amount of risk they are incurring.
Perhaps the most telling example is Treasuries, as illustrated by a rapidly flattening yield curve. The spread between the 10-year and 2-year notes narrowed from 136 bps in the post-2016 election sell-off to 33 bps by the end of June 2018. Spreads between 10-year and 30-year Treasuries were an even tighter 13 bps. In both cases, investors choosing to invest in the longer-dated maturities would take on significantly higher duration risk for only a marginal bump in yield.
Adding More Arrows to the Quiver
Shorter-dated fixed income securities have traditionally offered investors numerous favorable characteristics. Among them are liquidity, visible income streams and lower volatility. As central banks continue along their path toward policy normalization, bond investors can once again leverage these characteristics by incorporating short-term bonds into a broader fixed income portfolio in order to create their preferred risk/return profile.
For years there had been scant benefit for investors who prefer a relatively high allocation to cash and other liquid instruments to hold short-term bonds, as rates were often mired below 0%. A return to positive real yields now means that conservative investors no longer must choose between liquidity and earning a suitable level of carry.
Investors with a more traditional fixed income allocation would be well served to consider positioning along the front end of the curve as a complement to core bond portfolios. Driving home this point is the historic mismatch between risk and return in the Bloomberg Barclays U.S. Aggregate Bond Index (Agg), a popular benchmark for core bond portfolios. Although the yield-to-worst on the Agg recently climbed above 3% for the first time since 2011, the index’s duration remains just beneath its record high of 6.2 years, set earlier this year.
Shorter-Dated Bonds Exhibit More Favorable Risk Profiles
Source: Bloomberg, as of 6/30/18.
Bloomberg Barclays indices shown represent investment grade, fixed-rate debt of the U.S. bond markets described by their names.
Yield to Worst: The lowest potential yield an investor would earn - accounting for all provisions - short of a security defaulting.
Modified Duration: A measurement of a bond’s sensitivity to interest rates, with a higher number, measured in years, being more sensitive.
Rich valuations on longer-dated bonds expose investors to an elevated risk of capital loss. For example, the annual income on the generic 10-year Treasury note with a coupon of 2.875% would be wiped out if rates rose just 34 bps. On the 2-year note with a 2.5% coupon, it would take a much more pronounced 131 bps upward move in rates to render the investment flat for the year. Investors would be mindful to heed these disparate risk profiles as bond markets face visible headwinds, including an elongated credit cycle, tight spreads on corporate credit, still-manageable but rising inflation and the expectation of higher market volatility.
While the argument can be made that conditions merit an increased allocation to short-duration bonds, investors should still act judiciously when choosing how to optimally gain exposure to these maturities. Despite their shorter durations and higher liquidity, risks still remain in the front end of the curve. Given rich valuations across all tenors, active management may help investors avoid securities whose prices have outrun fundamentals. Strategies that place an emphasis on lowering correlations to core bond strategies would likely prove advantageous in the event of market upheaval.
Rather than tethering oneself to a benchmark, an absolute return strategy can enable investors to identify securities that meet their preferred risk/return profile from a wider opportunity set, regardless of geography. Individual countries are at different stages of credit and monetary cycles. Advanced economies that maintain accommodative monetary policy relative to their peers and foreign investment-grade companies benefiting from secular tailwinds may offer investors attractive risk-adjusted returns without forcing them to descend the capital structure or increase exposure to emerging markets.
Perhaps most importantly, we believe investors need to alter the mindset that has governed them for much of the post-crisis era. The days of distorted markets that enabled investors to pursue returns with only secondary consideration of the historical risk levels associated with many asset classes are likely in the past. The return of positive carry along the front end of the yield curve likely harkens elevated volatility across a range of riskier asset classes. Fortunately, the return of positive real yields on short-term bonds means such strategies are now less enticing. Instead, short-term bonds can be looked upon to do what they have historically provided investors: income generation and a potential dampener to overall portfolio volatility.
- The Personal Consumption Expenditure (PCE) Price Index, ex Food and Energy, a gauge of core inflation.
- TIPS, Treasury Inflation-Protected Securities, are government bonds that are periodically adjusted to account for inflation. Breakevens are the inflation levels implied by TIPS prices.