Capital Ideas^TM

With the Federal Reserve’s rate hikes potentially over, this year is already shaping up to be a favorable one for fixed income returns following a dismal 2022. Investors who rushed for the exits last year, sending money market fund levels soaring to $5.2 trillion, may be wondering if it’s time to retrace their steps.

At the same time, last year’s painful market reset may have held a silver lining. Short-term bond yields  have risen from near rock-bottom levels. They touched their highest figures in more than 15 years and remain compelling at an average of around 4% in early May. In certain parts of the market, high-quality AAA-rated bonds are yielding in the range of 5% to 6%, helping to provide attractive income as well as some cushion against further potential volatility.

“Starting valuations are one of the most attractive parts of today's short-term bond market,” says Vince Gonzales, fixed income portfolio manager. “There's a lot of incremental value compared to what you can get in cash-like investments, with some additional risk.”

The Federal Reserve raised interest rates by 0.25 percentage points in early May, a continued slowdown from its pace of rate increases in 2022 and one which many Fed watchers predict may be its last. As the Fed nears a possible pause or pivot, the market may be hitting an inflection point.

“Whenever you think about the end of a rate hiking cycle and the potential beginning of a cutting cycle, the front end of the Treasury curve has tended to be the most sensitive,” Gonzales says. “That presents opportunities for positioning in rates and in credit.”

What goes up, must come down

A big question facing investors is just how long short-term bond yields may remain at historically high levels.

While yields fell somewhat after the Silicon Valley Bank collapse, there is still potential for them to tick higher given the strength of the US economy, which could hinder a Fed pivot. John Queen, fixed income portfolio manager, notes that market players have largely split into two camps over whether the Fed has accomplished its mission of taming high inflation.

“Every time we get a new report that supports one camp or the other, you see significant volatility in the market,” Queen says. “That makes short-term bonds really interesting, where you’re getting a higher yield for longer than expected and you’re also a little more protected amidst the volatility.” He adds that shorter term bonds have lower duration, a measure of interest rate risk, compared with longer term bond strategies.

Two-year Treasuries are currently yielding about 0.48 percentage points more than 10-year Treasuries, a phenomenon known as a yield curve inversion that’s a common precursor to a recession. For comparison, 10-year Treasuries have yielded, on average, about 1.2 percentage points more than two-year Treasuries over the past two decades. A meaningful decline in short-term yields may occur if the yield curve reverts to its typical positive slope. These inversions typically unwind sometime after the Fed’s final rate hike.

“If inflation remains stickier than expected and the economy holds up, then we may be in for higher rates than the market’s currently pricing in,” Queen says. “My view is that rates will stay higher longer than market consensus, and the curve will probably stay inverted longer as well.”

If inflation remains sticky, the Fed may have less runway to raise rates compared to 2022 given troubles in the banking sector and concerns over a recession. Still, if rates drift higher, the higher income potential from higher starting yields would be a strong offset to any adverse price movements. If rates remain at these higher levels for longer, that could provide a longer horizon to earn attractive income.

To be sure, the market expects rates to fall somewhat but potentially remain at much higher yields than in the recent past. This presents the possibility of not just price appreciation but also compelling income to continue in the near term.

Some investors may be tempted to time their reentry to the market, watching inflation reports and the Fed for an all-clear signal. But they may find that they miss a market rebound.

“As information emerges on the direction of the economy, the market moves very, very quickly to incorporate that data,” Queen explains. “By the time there's clarity, the market may have already moved.”

For those investors that remain concerned about timing, averaging (the practice of investing a fixed amount on a regular basis, regardless of the share price) may provide an attractive way to reenter the market and pursue higher total return opportunities compared with cash or cash-like investments, depending on investment objectives and tolerance for greater risk.

Hunting for opportunities in short-term bonds

The short-term debt universe has breadth, ranging from Treasuries to corporate bonds and securitised debt. Investors receive a risk premium, or spread, on top of comparable Treasury yields when investing in sectors like corporates and asset-backed securities. Spreads are currently at attractive levels near or above their long-term averages.

“It presents so many different opportunities and types of high-quality credit exposures that you can construct within a portfolio,” Gonzales says. “We think the potential is there to amplify returns in terms of sector allocation and security selection.”

To be sure, a darkening outlook for the economic environment calls for discretion.

“We're still cautious on the outlook for credit over the next six to 12 months,” Gonzales adds. “We think there’s potential for continued volatility and further spread widening as the economy is likely to face headwinds and possibly slide into recession. It highlights the importance of focusing on sectors that have been resilient and avoiding areas that have deteriorating credit profiles.”

“Everyone's talking about how attractive money market funds are, but you're able to buy very high-quality securities — not just from a rating standpoint but from an underlying credit structure standpoint — at yields that are about 1.5 to 2 percentage points in excess of what money market funds currently offer,” Gonzales says. “I think it really highlights the value proposition of targeting an attractive yield on a very high-quality short-duration portfolio.”

In corporate bonds, where high-rated, short-term issuance is concentrated in the financial sector, opportunities are emerging as bonds have cheapened on the heels of banking industry turmoil.

Opting for a smoother ride

Whether it’s the path of interest rates, a potential recession or geopolitical risks, investors are parsing numerous variables in determining their next moves.

“As we think about all the uncertainties, it makes sense to remind ourselves of why we buy bonds in the first place,” Queen says. He offers the analogy of heading on a long distance road trip and opting to drive a sensible sedan over a fast but finicky race car. “We own bonds as part of a broader portfolio aiming to basically smooth the ride and lower volatility.”

When looking at the fixed income landscape, short-term bonds stand out for their attractive valuations and limited volatility, providing an attractive stepping stone from cash.