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Income is back in fixed income. The front end of the curve may offer a way to earn that income while avoiding some of the risk.
Joseph Graham, CFA
Managing Director & Investment Strategist
Attractive yields while limiting rate risk
We’ve written and spoken a lot about the potential benefits of short-duration credit over the last few years. This focus has been motivated by substantial evidence for long-term outperformance at the short end of the yield curve, as well as the needs of investors both to earn a return on uninvested cash reserves and to diversify away from the term risk prevalent in the rest of the fixed-income market.
Those needs are still pressing today. The drag of holding cash is expensive as inflation keeps running well in excess of pre-pandemic norms. Investors need ways to outpace this inflation with the portion of their portfolios designated for principal protection.
We believe diversifying term risk should be a priority for fixed-income investors. Though the yield picture for longer-term fixed income has certainly improved since the beginning of 2022, the yield curve remains stubbornly flat overall and inverted at key points (see Figure 1), providing very little, if any, compensation for taking on incremental interest-rate risk.
Figure 1. Short-term rates have adjusted to reflect future fed rate hikes
US Treasury yield curves for indicated dates
Source: Bloomberg. Data as of 31/12/31/2022. A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year US Treasury debt. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.
Longer-term interest-rate uncertainty — compensation known as “term premium” — may not be properly reflected in long-term bond yields (see Figure 2).
Figure 2. Negative term premium still a long way from typical
Term premium on 10-year US Treasury note and the year-over-year change in the US Consumer Price Index (CPI), June 14, 1961-December 31, 2022
Source: Bloomberg and Federal Reserve Bank of New York. Data as of 31/12/312022. Term premium represented by ACMTP10. Inflation represented by the year-over-year change in the US Consumer Price Index (CPI). 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 and expenses, and are not available for direct investment.
Beyond the tactical consideration of today’s term premium, 2022 taught investors that one common risk — the rate risk that comes with longer-term fixed income — can affect every investment in their portfolio together. Adequately priced or not, this risk and its impact on portfolios should be diversified, and short-duration credit is one potential way to limit rate risks associated with longer-term bonds.
The evidence for outperformance of short duration has only improved over the last year, as rising rates damaged longer-term fixed income performance in 2022. Short-duration credit indexes significantly outperformed longer-duration credit segments, with rising rates the primary driver of negative returns as opposed to credit events, shown in Figure 3.
Figure 3. Duration exposure increased the negative impact of rising rates
Contribution to index total returns in 2022 as of December 31, 2022
Source: FactSet. Data as of 31/12/312022. Bloomberg indexes: Bloomberg US Treasury Index, Bloomberg US Aggregate Index, Bloomberg Non-Agency CMBS (commercial mortgage-backed security) US Aggregate-Eligible Index, Bloomberg US Corporate Index, Bloomberg US Corporate High Yield Index. Leveraged Loans = Credit Suisse Leveraged Loan Index. Past performance is not a reliable indicator or guarantee of future results. The historical data shown in the chart above are for illustrative purposes only. Due to market volatility, the market may not perform in a similar manner in the future. 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 and expenses, and are not available for direct investment.
The low-risk anomaly and higher risk-adjusted returns
Short-duration credit has historically produced higher Sharpe ratios than long-duration credit, as shown in Figure 4. This outperformance of short duration over the last few decades is not all that surprising. Anomalous, risk-adjusted returns for low-risk market segments are common across asset classes and time periods.1
Figure 4. Short-duration core bonds produced higher Sharpe ratios
Sharpe ratios by credit quality and effective duration within the Bloomberg US Aggregate Bond Index, 31 December 31, 1997-31 December 31, 2022
Source: Bloomberg. Data as of 31/12/2022. 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.
The reasons for this anomaly are varied, but some of the most important are as follows:
- Investor attention on higher risk-and-reward opportunities resulting from overconfidence, agency issues, or justification of the time and effort put into the research process — and consequent inattention to low-risk areas.
- Constraints on leverage, particularly in low-spread asset classes where frictional costs inhibit leverage or areas with non-normal distributions of returns. Negatively skewed and fat-tailed returns are less attractive to risk-averse or leveraged investors.
- Non-economic constraints arising from agency issues commonly found in investment guidelines and investment management agreements that limit investor flows to certain issuer types, qualities, registration types, or maturities.
A flexible, multi-sector approach to find excess returns
We often see these behavioural biases in action within short-duration credit. As allocators reel from the speed and magnitude of the rate repricing of 2022 and prepare for a likely recession in 2023, they now have even less reason to go further afield with short-term rates well above their 2021 lows.
As a result, opportunities abound for mandates that can be flexible. For example, currently, investment-grade, securitised issues — such as AAA-rated, short-duration CMBS (commercial mortgage-backed security) and ABS (asset-backed securities) — offer excellent overall yield and spreads in spaces where the underlying credit is performing well, and the structure is likely to weather even a severe recession (see Figure 5).
Figure 5. Attractive spreads on AAA-rated, short-duration CMBS and ABS
Option-adjusted spreads (OAS) on indicated indexes, December 31, 2016-31 December 31, 2022
Source: Bloomberg. Data as of 31/12/312022. Indexes: Bloomberg AAA CMBS 1-3.5 Year Index, Bloomberg AAA ABS 1-3 Year Index and the ICE BofA 1-3 Year A-Rated Corporate Index. 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.
Key Takeaways
Capitalising on the short-duration anomaly with a flexible, multi-sector mandate allows a well-resourced manager to balance liquidity needs, diversify risk, and earn excess returns from sector rotation and security selection.
Investors focused on return-seeking segments of their portfolios may want to consider a dedicated, short-duration high-yield mandate. Attractive historical returns and an excellent yield-and-spread environment leave the asset class attractively positioned on both a relative and absolute basis.
1Blitz, David and van Vliet, Pim and Baltussen, Guido, The Volatility Effect Revisited (August 26, 2019). Available at SSRN: https://ssrn.com/abstract=3442749 or http://dx.doi.org/10.2139/ssrn.3442749
Important Information
Unless otherwise noted, all discussions are based on US markets and US monetary and fiscal policies.
Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.
No investing strategy can overcome all market volatility or guarantee future results.
The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.
Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
Equity investing risks
The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognise that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies.
Fixed-income investing risks
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, 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.
The credit quality of fixed-income securities in a portfolio is assigned by a nationally recognised statistical rating organisation (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 principal on these securities.
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Glossary & index definitions
Treasuries are debt securities issued by the US government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
A basis point is one one-hundredth of a percentage point.
The US Federal Reserve (Fed) is the central bank of the United States.
The federal funds (fed funds) rate is the target interest rate set by the Fed at which commercial banks borrow and lend their excess reserves to each other overnight.
Yield is the income returned on an investment, such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investment’s cost, current market value, or face value.
Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year US Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
Term premium is defined as the compensation that investors require for bearing the risk that interest rates may change over the life of a bond.
The ICE BofA 1-3 Year US Corporate Index is an unmanaged index comprised of US dollar-denominated, investment- grade, corporate debt securities publicly issued in the US domestic market with between one and three years remaining to final maturity.
The ICE BofA 0-3 Year AAA CMBS (commercial mortgage-backed securities) Index is an unmanaged index comprised of US dollar denominated AAA-rated commercial mortgage-backed securities publicly traded in the US domestic market with between zero and three years remaining to final maturity.
The ICE BofA 0-3 Year ABS (asset backed securities) Index is an unmanaged index comprised of US dollar denominated AAA-rated asset backed securities publicly traded in the US domestic market with between zero and three years remaining to final maturity.
The ICE BofA 1-5 Year High Yield Index is an unmanaged index comprised of US dollar denominated high yield debt securities publicly traded in the US domestic market with between one and five years remaining to final maturity.
The ICE BofA BB/B High Yield Index is an unmanaged index comprised of US dollar denominated BB- and B-rated debt securities publicly traded in the US domestic market.
The ICE BofA 1-3 Year BB/B High Yield Index is an unmanaged index comprised of US dollar denominated BB- and B-rated debt securities publicly traded in the US domestic market with between one and three years remaining to final maturity.
The Bloomberg US Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the US investment-grade, fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.
Bloomberg AAA CMBS 1-3.5 Year Agg Eligible Index is the AAA-rated CMBS component of the Bloomberg US Aggregate Index with maturities between 1 and 3.5 years.
The Bloomberg AAA ABS 1-3 Year Index is the AAA-rated ABS component of the US Aggregate index with maturities between 1 and 3 years. The ABS Index has three subsectors, credit and charge cards, autos, and utility.
The Bloomberg Investment Grade Corporate Index is the Corporate component of the US Credit index which contains publicly issued US corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. The corporate sectors are Industrial, Utility, and Finance, which include both US and non-US corporations.
The Bloomberg 1-3 Year Corporate Index is a subset of the Bloomberg Investment Grade Corporate Index which with maturities between 1 and 3 years.
The Bloomberg US Treasury Index is the US Treasury component of the Bloomberg US Government Index and contains public obligations of the US Treasury with a remaining maturity of one year or more.
The Bloomberg Non-Agency CMBS Index is the non-agency CMBS component of the US Aggregate index.
The Bloomberg High Yield Corporate Index covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moodys, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included.
Bloomberg Index Information
Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg owns all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material or guarantee the accuracy or completeness of any information herein, or make any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, shall not have any liability or responsibility for injury or damages arising in connection therewith.
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.
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This is a sponsored article from Lord Abbett.
