Faced with the dilemma of historically low bond yields and high equity market valuations, investors are using short-term bonds to park assets until they decide what to do next. But instead of renting a short-term bond “parking space” solution, some investors are considering the benefit of owning a lower-duration solution — one that’s diversified across fixed-income sectors and designed to provide income and capital appreciation.
A CHALLENGING MACRO ENVIRONMENT
Fixed-income investors are facing a challenging macroeconomic environment amid the recovery from the global pandemic. While the fed funds target rate range remains anchored at 0.0% to 0.25%, we’re seeing higher levels of inflation and consumer inflation expectations as global economies reopen, while the outlook for future inflation — based on the Fed’s 10-year model and current trading in 5-year forwards — remains low. As a result, interest rates may climb higher, but not significantly (see Figure 1).
Source: Bloomberg, Federal Reserve Bank of Cleveland, Federal Reserve Bank of St. Louis, University of Michigan, data as of 05/31/21.
For now, real yields (the level of interest rates above or below the inflation rate) are negative. Bloomberg U.S. Aggregate Bond Index (Agg) real yields have been below -1.5%, compared to their long-term average of +1.9%. Real yields for the Bloomberg Short Aggregate Index (Short-term Agg) are -2.9% — well below the average of +1.0% since 2000 (see Figure 2).
Source: Real yields = Yield-to-worst of the index minus PCE core inflation. Bloomberg, data as of 05/31/21.
YIELD IS MOST CONSISTENT, PREDICTABLE COMPONENT OF TOTAL RETURN
In fixed-income investing, returns are driven by income returns, or yield, plus or minus changes in price as rates fall or rise. Since 2000, almost 80% of returns for the Agg have been driven by income. But as we move toward the short end of the curve, they become more vital. For the Short-term Agg, income returns make up more than 90% of the returns over the last two decades (see Figure 3).
Source: Bloomberg, Barclays Live, data as of 12/31/20
The short end of the yield curve is often referred to as the sweet spot, where investors typically can find the most attractive risk-reward profiles. Today, investors need to consider an approach that allows them to remain invested in key sectors that can generate income, while also navigating the uncertainty of interest-rate moves and market volatility.
THE NEED FOR A LESS GENERIC SOLUTION
The Agg and the Short-term Agg delivered annualized returns of 4.9% and 3.8% since 2000, respectively. These traditional benchmarks changed their complexion after the global financial crisis because the government issued more debt. The Agg extended duration and lowered yield because government bonds crowded out corporate and securitized bonds in the index. While duration for the Short-term Agg is relatively constant, yields are currently very low. Fixed-income investors limit their opportunity set when they focus on benchmark-tracking or benchmark-hugging strategies.
Overwhelmingly, the Morningstar Short-Term Bond category uses various versions of shorter, all corporate or government-corporate indices — offering little diversification by sector, credit quality or country allocation, where wider spreads and higher yields are often found. Rather than rushing into renting these benchmark solutions, investors could benefit from owning lower-duration, diversified fixed-income solutions that invest in high income-producing sectors, such as high-quality high yield, emerging market debt and broad use of structured assets. Together with investment-grade corporate bonds, these sectors typically experience low correlation. They can provide attractive income and capital appreciation, while keeping overall duration reasonably low.
Better returns may be attributable to the inclusion and diversification of higher yielding sectors like emerging market and high-yield debt, which typically exhibit low correlations to the Bloomberg 1-5 Year Gov/Credit Index (see Figure 4).
Correlation between applicable Bloomberg Indices. Source: Bloomberg, data as of 06/30/21.
Utilizing high yield and emerging market debt in a short-duration portfolio offers materially higher yield without increasing duration. Both offer significantly higher yield per unit of duration, making them attractive sectors that can enhance the total return potential of a portfolio (see Figure 5).
Yield to worst and duration represented by applicable Bloomberg Indices.
Source: Bloomberg, data as of 07/30/21. * For 1-5 Global Agg Corp, data start from 04/18.
Investors faced with macroeconomic and capital market uncertainties have been moving into short-duration fixed-income solutions. Dominated by shorter, all corporate or government/corporate debt, these parking space solutions offer little diversification by sector, credit quality or country allocation — where wider spreads and higher yields are often found.
Investors could benefit from investing in a lower-duration, diversified fixed-income solution that invests in high income-producing sectors, such as high-quality high yield, emerging market debt and broad use of structured assets. Together with investment-grade corporate bonds, these sectors typically experience low correlation and can provide attractive income and capital appreciation while keeping overall duration reasonably low. Filtering to be selective when choosing the bonds to own — not rent —can help to improve quality, yield and liquidity.
Edward Kerschner is chief portfolio strategist at Columbia Threadneedle Investments. Ronald Stahl is senior portfolio manager and head of short duration and stable value at Columbia Threadneedle Investments.
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