Global Perspectives: Short duration takes the spotlight in fixed income

Adam Hetts: Welcome back to Global Perspectives. Today we’re talking short duration with Dan Siluk and Jason England, who are both Global Fixed Income Portfolio Managers. And I am Adam Hetts, of course, your host, Global Head of Portfolio Construction and Strategy here at Janus Henderson. So, Dan and Jason, welcome to the show.

Dan Siluk: Yeah, thanks for having us.

Hetts: Yeah, my pleasure. And so we’re talking short duration today because short durations are a hot topic for investor fixed income portfolios. Just catching you up year to date, in case you’ve been living under a rock, we’ve had this historic pace of Fed hikes, which has been brutal for interest rate volatility and fixed income portfolio returns. But now we’re at this point with plenty of silver lining; in fact, an inverted yield curve in the U.S. that’s actually a boon to fixed-income investors, who now have the opportunity to increase their credit quality in portfolios and shorten their duration, while also increasing yield, potentially, at least looking at the U.S. yield curve.

I literally just got off a client consultation about 20 minutes ago. The gist of that conversation was, for all the pain and confusion that we had earlier this year, and all the complicated solutions you had to take to navigate fixed income, things have gotten a lot simpler, where you can be simpler, be higher quality, be lower duration, and be higher yield in your fixed income. So it’s great timing to have Dan and Jason here to kind of walk us through the global short-duration opportunity set.

And Jason, we’ll start with you. I first want to hear how you’re talking to investors and clients in general, the ones that just don’t have short duration in their fixed income portfolios, these ones that still own only intermediate. What’s your take on why they should have both short and intermediate duration, and what are the risks of only owning intermediate duration in a fixed income portfolio right now?

England: Great question. Us boring bond investors finally have something exciting to talk about with these attractive yields now that we’re seeing. You can actually get yield carry in your portfolio. So, one thing to be careful with is, do you own too much duration in your portfolio? You want to have less interest rate sensitivity, so that’s why you would want to own some short duration right now. And these flat and inverted global yield curves afford very attractive front-end yields, so you can take less risk in your portfolio and still get the yield of a longer intermediate-term bond fund. So it’s good to have a little bit of both, or mixture, or even place more in the front end right now. The one thing to note on that is, a pause does not equal a pivot for the Fed. Higher for longer is what they’ve been telling us, and the old mantra of don’t fight the Fed is coming back into play here. And really the last note I’d hit here is that the pain to gain that we felt in fixed income this year, in Agg-based portfolios, the yield has gone up close to 300 basis points, yet they’re down 15%. Where in ultrashort duration portfolios up about 300 basis points of yield, yet it’s only down about 1%. So that just shows you the benefit of owning less duration right now.

Hetts: I like when you say the “pain to gain,” to kind of recap everything we’ve kind of been through this year, and that’s been the gist that leads us to this silver lining, I think, on the short end of the curve. So what do you say to the folks that own intermediate and are saying, we’ve had this pain to gain? This is the last time to kind of sell low out of intermediate and miss the pivot. It kind of goes back to your point about “pause does not equal pivot,” but can you expand a little bit about how you feel that the short versus intermediate might play out from here?

England: I mean, I think that the key thing is, the Fed still has more room to go in their hiking cycle. We’ve priced in another 150 basis points as we’ve seen in their revised dot plots of the September meeting. So there is more pain to be had, but you’ve already seen the movement in the front end, of 350-60 basis points, call it. So really, you’re probably not going to see that double again here in the front end. So you’re only taking about a tenth of the duration risk in the front end and still getting an attractive yield versus the intermediate part of the curve, where you’re taking sometimes over six years in duration, yet still getting roughly around a 4.5% yield. So the inverted curve is just benefiting the front end with more reward for the yield you’re getting with less duration exposure.

Hetts: And I think that the folks that don’t own short duration are probably in the minority, at least in my experience so far this year, in client consultations. Dan, you’re based over in Sydney, with Jason over in California, you two are a part of a global team. I think most that do own short duration are really focused on the U.S. with a home bias in fixed income, at least when it comes to U.S. portfolios. So why is your strategy global, and what kinds of benefits do you feel you get out of a global short-duration approach as opposed to just a U.S.-centric approach, which seems to be most popular? And then can you just give some examples of how that global allocation should be important over the next year or two?

Dan Siluk: Yeah, absolutely, thanks, Adam. Look, around the world, all countries are at different points in their economic cycle, and so that’s why you want a global portfolio, to take advantage of those different economic environments and economic cycles. And while, yes, the Fed is the central banker for the globe, and rates globally do tend to be quite highly correlated to U.S. rates in times of crisis. But what I would say is that, in times of crisis, there’s really one play in the playbook, and that play is to cut rates to zero and it’s to dial up QE [quantitative easing]. And we saw that during the Global Financial Crisis, and we saw that in the aftermath of the COVID crisis, and it did work effectivity. And you can, I guess, call it central bank coordination to get out of these crisis events. However, the environment that we’re in today is quite different, and while there is some synchronicity as opposed to coordination, that synchronicity is starting to break down, because, as I mentioned, different countries are at different points in their economic cycle. And so I can reference a few here: New Zealand, as an example, the Reserve Bank of New Zealand was the first central bank to get rates into restrictive territory. It’s already seen a 15% drawdown in house prices across their major cities, and economic growth is slowing, which is the intent of high rates, to essentially bring demand down to combat inflation. So as we look around the globe, the New Zealand rates is one area where we actually like to take some exposure because we think they’re nearer to the end of their hiking cycle than the Fed. Whereas you look in Europe, and Europe still has a plethora of issues, from the energy crisis as a result of the Russian-Ukraine war, [to] uncertain fiscal policies we’ve seen out of the UK in the last couple of weeks. It’s created a lot of volatility in markets, and the ECB was pretty slow and late, and the pace of its hiking cycle has not kept up with some of the other central banks, and so we feel that they need to move ahead or move forward. And so other trades could be shorting the European rates, and you can essentially put on compression trades. So whether it’s New Zealand versus Europe or U.S. versus Europe, where you expect those rate curves to compress, I guess the bottom line is that in a time of crisis, central banks go down an elevator, but as they recover from those crises and they deal with idiosyncratic issues in those particular nations, they come up an escalator, and where they get off that escalator will vary.

Hetts: And so the catch, usually, about going global with your fixed income is then, of course, introducing currency risk, which can dominate normal bond volatilities. So how do you guys deal with this?

Siluk: For us, volatility and risk management is one of those key tenets, we recognize that owning FX [currency] risk is not conducive to running a low-volatility portfolio. So, in a U.S.-dollar-based portfolio, we would hedge up that non-U.S. dollar currency risk. We assess based on the relative value to that U.S. curve. So what that means is, after the cost of FX hedging…so today, as an example, you can own an Australian dollar asset, and after hedging pick up about 120 basis points doing the FX hedge. So, essentially, you’re selling a low-yielding currency, the Aussie dollar, to buy a high-yielding currency, the U.S. dollar. Now that interest rate differential, in Europe in the FX forward curve, is around 300 basis points. So look for companies who may be issuing in offshore currencies, position for those, overlay that with an FX hedge position to out the outright currency risk, and still be able to pick up on interest rate differentials.

Hetts: So if I went with that U.S. dollar-based example, for all the concern about globalizing not just being about taking currency risk, but that ex-U.S. rates can be a lot lower than the U.S., it’s actually one and the same answer because you’re hedging currency risk. And then with the interest rate differentials in your favor, i.e., U.S. rates are higher than ex-U.S., you’re actually getting paid to hedge, as you just laid out.

Siluk: Absolutely, correct, you are getting paid to hedge today as a U.S.-dollar investor, absolutely.

Hetts: Okay, thanks, Dan. So then, Jason, another thing to hit on is, sticking again with the U.S.-based example, which is where I’m based, I know it’s really common here to try to take advantage of that inverted yield curve. It’s just a lot of flows into just basic T-bills or other very short-duration cash substitutes, so obviously extremely high quality, and not thinking global, not introducing any credit. So what would you say to those investors that are of the simple-is-good mentality as far as trying to exploit the inverted curve?

England: Yeah, I think that’s a clean and easy way to do it, but it’s not necessarily optimizing it as much as you can. By investing in just T-bills, even if you started the year on a one-year T-bill, you’re still going to feel some pain this year because we’ve seen front-end rates move so much. So it doesn’t necessarily always mean you’re going to be 100% safe sitting in T-bills. The other thing is you’re going to miss out on some of the extra spread you’re getting in investment-grade credit right now. So, you know, T-bills, one year may be around a high 3%, maybe around 4%, but you can get that, over 5%, in investment-grade credit with one-year maturity, A-rated names. So really, you’re just looking to optimize that front end as much as you can by still trying to stay high in quality, and I think that’s where you miss out if you just lock in T-bills or T-notes right now. And as the Fed nears the end of the tightening cycle – I’m not saying we’re there yet, but when they do near that, you’re going to have the ability in a short-duration product to be able to optimize your duration some as well, where in the T-bill you’re just going to have reinvestment costs as that rolls down to maturity. Then you’re going to have to go out and try to find something to invest in, whereas being in a short-duration fund or ETF you can manage that duration tactically and adjust it as you see the Fed nearing the end of their tightening cycle.

Hetts: Dan, anything you want to add to that?

Siluk: Yeah, absolutely. I think in recent years, particularly post the COVID crisis, even between Global Financial [Crisis] and COVID, rates were very low. Obviously, a year, year-and-a-half ago, the two-year Treasury was only yielding about 10 basis points. So this is what led to, I think, people taking a lot more risk in their portfolios in order to chase that yield. And the whole mantra of TINA, “There Is No Alternative,” to equities, or even a fixed income manager, there is no alternative to essentially taking on that extra risk, whether it’s illiquidity risk, going into private debt, or whether it’s going down the capital structure or credit spectrum in order to drive yield, so essentially it led investors to chase yield. However, today, we see the return of, I guess, what we’ve coined, and it’s bounced around in the markets a little as well, is CINDY. So, CINDY stands for “Credit Is Now Delivering Yield.” So essentially, we’re saying, “Goodbye, TINA. Hello, CINDY.” You can invest in short-dated investment-grade credit today and pick up, as Jason spoke about, a decent yield pickup just in the front end of the curve. So one-, two-year paper, you can get anywhere from 80 to 120 basis points above the Treasury curve. And you can do so in household names, ones whose balance sheets are strong, where cashflows are somewhat stable and predictable. So we prefer to focus on non-cyclical type names rather than cyclical names. But we’re excited about the front ends of rates curves and credit curves because yields just haven’t been this high in a long, long period of time.

Hetts: Thanks, and I knew you would sneak that CINDY acronym in there. You guys love that, and for good reason. So maybe the last question then, to zoom out a little bit, Jason, on the macro picture. So today is October 12, can you recap where we’re at on the current Fed funds rate? That’s the layup for you. And then what do you see as the terminal rate of this hiking cycle? And then what’s the risk to the short-duration asset class if you’re wrong and the Fed stays hawkish, and the terminal rate ends up a lot higher than what you expect?

England: Yeah, sure. I mean, it’s been a big move off zero very quickly from some unusually large hikes of 75 basis points over the last three meetings. So now they’ve raised the Fed funds rate by 300 basis points this year, so the upper band is sitting at three and a quarter. They’re pricing in another 150 basis points, looking at their dots, and the market’s pretty much pricing that in. So that would give us a terminal of about four-and-three-quarters on the upper band. That’s probably fair. I think they’re going to end up somewhere around that, plus or minus maybe a 25 basis-point hike. Powell was pretty clear in his press conference that they were going to get there, so take him for his word. The old adage that the Fed overpromises and underdelivers, this time around, because inflation is so high, really hasn’t come into play. I think they are going to push forward as much as they can. So I guess you can be wrong and maybe they go higher than that.

The other key thing here is not just how high the terminal ends, but historically over the last five hiking cycles, the two-year Treasury has peaked out 50 basis points higher than the last hike, so where they’ve ended up with the terminal rates, so that’s something also to consider. So there is some potential for more volatility in the front end. So as a front-end investor, you need to make sure that you minimize the amount of duration you have in your portfolio and make sure that, as you are going to call that turn or that peak in terminal, that you’re tactically adding back and that you’re not getting ahead of yourself. You’d almost rather be late than too early, and I think that’s kind of the key thing to remember there. And then the other thing is that there is more cushion right now for a front-end portfolio, because if you look at it, right now where yields are at, it’s only about 80 basis points of cushion for an Agg or intermediate-type bond fund. If we saw yields continue to go higher, you have only 80 basis points of cushion, where you have about 800 basis points in a short-duration vehicle. So there is more cushion now that we’ve seen this inverted curve with yields much higher, so that’s the one thing, the benefit, at the front end as well. So the final thing is, as you’ve probably heard when Dan and I talked, we’re excited to talk about front-end yields now with these attractive levels that we’ve seen, and we haven’t seen this in years.

Siluk: So for me, the other benefit of being in the front end of the curve is, obviously today curves are quite deeply inverted. So the two-year rate is considerably higher than the 10-year rate, and this happens when we approach recession, and particularly in this environment of high inflation where central banks need to raise rates in order to combat inflation. But there will come a point when the Fed has their clear and convincing evidence that inflation is slowing, and then they start to change their focus from inflation to broader economic growth. So we’re going to see unemployment tick up, we’re going to see growth fall below the trend. And at that point, there will be a stage where the Fed will have to cut rates in order to refocus their attention on economic growth. Now, as we spoke about earlier, and Jason mentioned, that a pause does not mean a pivot, and we’re not suggesting that this is going to happen any time soon, but when it does, that front end of the curve is going to fall quite significantly. It will outperform. So yields will fall at a faster rate in the two-year part of the curve than in the 10-year part of the curve, so you’re also getting the additional benefit of capital price to appreciate in the front end of the curve when curves re-steepen when their more natural and normal shape reasserts itself.

Hetts: Well said, guys. Thanks again for the tour of short duration. Definitely a hot topic, and I think an important topic for all fixed income investors right now. And ripe for opportunity as long as it’s navigated correctly, essentially in a global active sense, per Dan and Jason’s comments.

England: Thanks a lot, Adam.

Siluk: Thanks, Adam.

Hetts: And thanks, listeners, for joining again. If you haven’t already, you can find more Global Perspectives on Spotify or iTunes, or wherever else you listen. And, of course, check out the Insights section of the Janus Henderson website for more of the views from our firm. Thanks again and see you next time.