Finding Sanctuary in Short Rates
With a degree of uncertainty lingering in fixed income markets, an allocation to short rates can provide some portfolio defensiveness and a better yield return per unit of duration than further along the curve.
Following the brutal sell-off in 2022, this was supposed to be the year that bonds performed. It therefore seems ironic that, with central banks close to having peak rates in place, there has been yet another leg higher in bond yields. There are undoubtedly concerns over high deficits and substantial amounts of issuance that the market will have to absorb in an environment where central banks are running down their balance sheet holdings.
However, the main source of bearish tension has been the slower than expected decline in inflation and, in the US at least, more resilient growth. The result is that that central banks have indicated rates will stay elevated for a long period to come. The markets have responded by unwinding some of the pricing of rate cuts but by no means all, with the Fed funds futures still pricing close to 75 bps of policy easing in 2024, while the ECB has at least one rate cut by the end of Q3 20241.
With medium-term easing still at the forefront of the market’s collective mind, there remain risks to the bond market if data stays strong. Given the substantial tightening in monetary policy already put in place, a resilient economy may seem unlikely but higher oil prices could push headline inflation rates higher and labour market strength is only gradually easing.
In addition, seasonally, September and October are a tricky part of the year for fixed income with debt management offices and corporates using the re-opening of the market post the summer lull in trading to issue bonds. Returns from the Bloomberg US Treasury Index have been positive in these two months in only three of the last 10 years and average -0.61% in September and -0.29% in October1. In short, if data does not start to soften and the market suffers supply indigestion, then yields could remain elevated in the coming weeks.
Investors may therefore feel more comfortable sticking to the front end of the curve for a few key reasons:
- The Fed, the ECB and the BoE have all indicated that central bank rates are close to peaking. Stronger than anticipated data could still force their hands into a further tightening but given recent bond market price action this is likely to see yields along the curve shift higher rather than see the curve more heavily invert. The shorter duration of the front end is more defensive.
- The front end of the curve is more tied in to policy rates and less sensitive to supply pressures.
- An inverted yield curve means higher yields at the front end. This results in short maturity funds having a far better yield return per unit of duration than further along the curve.
Sticking to the front end of the curve would have worked well for investors year to date. For instance, returns from the Bloomberg US Treasury Bill: 1-3 Months Index have been 3.66% and it currently has a yield-to-worst of more than 5.4% against returns of -2.4% for the Bloomberg US Treasury Index and a current yield-to-worst of close to 4.9%1.
Adding Credit Risk for Higher Returns
The idea that rates will need to stay on hold for an extended period of time is predicated on the need to bring inflation down in an environment of still resilient growth and labour market strength. This is a continuation of the current backdrop and has so far this year proved a supportive one for credit. Spreads to government bonds have tightened in from the levels seen following the Silicon Valley Bank crisis. At this juncture, balance sheets for investment grade issuers look stable with the upgrades/downgrades ratio around 1 in the US but well above 1 for European issuers2.
There are risks of credit-spread widening on the back of a more pronounced slowdown but, importantly, the yield-duration trade-off is now so favourable that there would have to be significant disruption to market levels for the price losses in the return indices to outweigh the yield. The chart below shows how the ‘breakevens’ on three short-dated indices have sharply improved during the past 18 months.
Historically High ‘Breakevens’ Point to Resilience
Breakeven rates are the index yield-to-worst divided by the option-adjusted duration. What this indicates in the case of the US index is that the yield would need to increase by in excess of 4% for the price losses incurred to wipe out the annual yield. This is just a rule of thumb but should give investors some comfort of earning positive returns given a move of this magnitude looks unlikely from current levels, either via a rise in the underlying Treasury yield or as a result of spread widening.