Turmoil Creates Opportunity for Short Duration Bonds

Stubbornly high inflation and hawkish central banks around the globe have pressured fixed income asset classes, with many posting meaningful losses in the first half of 2022. However, this year’s significant shift higher in bond yields, particularly in shorter-maturity securities, can offer investors compelling yield with less interest rate risk. We believe that our multi-sector approach to managing low-duration¹ portfolios can help diversify risk while tapping in to parts of the market that historically offered one of the best returns per unit of risk.

Fed Tightening Has Triggered Volatility

After more than a decade of heightened stimulus measures that sent yields to multi-decade lows and suppressed volatility, the Federal Reserve is withdrawing liquidity and hiking interest rates in response to multi-decade-high inflation. Unsurprisingly, the central bank’s moves have been highly disruptive, as evidenced by performance across asset classes this year. In the U.S., the two-year Treasury yield ratcheted up to reach a two-year high of 3.43% in mid-June after the Fed sprang into action to stamp out inflation, a significantly sharper move than in previous tightening cycles.

The volatility in Treasury yields has also pressured credit spreads² wider across fixed income sectors with credit risk. Historically, returns on Treasuries and credit sector performance have been negatively correlated,³ but that has not been the case for much of this year. As a result, losses on short duration corporate credit in the first half of 2022 exceeded those experienced in late 2008 when credit spreads widened out to over 700 basis points (bp).⁴ The downturn also shows how vulnerable short-term credit was in mid-2021 when credit spreads and Treasury yields were at historically low levels, offering little cushion when both started moving higher.

Flatter Yield Curve Benefits Short-Term Bonds

The repricing of yields has led to a significantly flatter yield curve, so investors can receive nearly the same yield in short-term bonds as they would from longer-maturity credits—at a fraction of the interest rate risk. Furthermore, these increased yields can buffer the impact of rising rates and offer significantly more cushion than a year ago.

Figure 2 shows the increase in yield that would be required to fully offset the current yield, turning total return negative. For context, in late July, the Bloomberg U.S. Corporate 1–3 Year Index could handle a yield increase of 200 bp before producing a negative return, compared with only 60 bp at the beginning of the year. This could serve as a tailwind to total returns going forward.

Multi-Sector Approach Adds Flexibility

A broad multi-sector approach to managing a low-duration portfolio that also incorporates an actively managed liquidity sleeve can help to limit risk by diversifying across sectors and maintaining ample liquidity even when historical correlations break down. Our multi-sector capability gives us the flexibility to add exposure to the fixed income sectors where we identify securities with higher risk-adjusted yield potential.

For example, in investment-grade corporate credit, short-maturity debt has provided meaningfully higher risk-adjusted returns than longer-term bonds. This theme is consistent across other short-maturity bonds with credit risk. From December 2002 through June 2022, the information ratio⁵ of the average one‑year rolling excess return⁶ of investment‑grade corporates in the one‑ to three‑year maturity range was more than three times higher than the same measure for 7- to 10‑year investment‑grade corporate bonds.

Liquidity to Navigate Market Uncertainties

Across our low-duration strategies, we balance our diversified multi-sector portfolios with an actively managed liquidity sleeve consisting of very short-term debt instruments and principal paydowns from securitized products such as mortgage- and asset-backed securities. Our thoughtful approach to liquidity management can afford the portfolios with incremental yield while maintaining an ample source of organic liquidity to navigate market uncertainties—a key consideration in an environment of rapid central bank tightening and volatility.