Thanks to changes brought on by interest rate volatility, core bond investors can now significantly shorten the duration of their fixed income portfolios without meaningfully sacrificing credit quality or yield. Global Head of Portfolio Strategy and Construction Adam Hetts explains why this could be the silver lining bond investors have been seeking.
Faced with historically poor year-to-date core bond performance, fixed income investors are searching for a silver lining. On a purely rational (and arguably wise) basis, U.S. 10-year Treasury yields nearing 3% make for a compelling case to “buy low” or "average in" to the same intermediate duration fixed income that drove the historical losses. Still, it’s not surprising that many investors are reluctant to own more of what has caused them so much pain.
Luckily, the nature of this year’s interest rate volatility has indeed produced a silver lining for core bond investors: The yield curve shift has not been parallel and the short end of the curve has risen dramatically compared to the longer end. In plain English, this means core bond investors have a new opportunity to dramatically shorten their portfolio duration (i.e., reduce interest rate risk) while giving up substantially less yield than they would have been forced to in the recent past.
Seasoned – or should I say, exhausted – bond investors will recall a similar phenomenon in late 2018 when the yield curve flattened and the 2-year and 10-year Treasury rates converged near 3%, generating the same opportunity for investors to shorten duration while forgoing only a small amount of yield.
One potential challenge to this silver lining is that many investors are focused on continued rising rates in the short end of the curve due to upcoming central bank activity. While this is undoubtedly a source of future volatility, investors would be well-served to remember that short-term fixed income is, well, short duration, and that it is less sensitive to rate increases compared to the longer end of the curve.
To conclude and illustrate, let’s shift perspective from Treasuries to more typical investment benchmarks: The Bloomberg U.S. Aggregate Bond Index (Agg) and Bloomberg U.S. Aggregate 1-3 Years Index.
A Flattened Curve and Silver Lining for Short Duration
Source: Bloomberg, as of 26 April 2022.
The bottom line is, thanks to the changes brought on by interest rate volatility, core bond investors can now significantly shorten the duration of their fixed income portfolios compared to a year ago without meaningfully sacrificing credit quality or yield – the silver lining they’ve been seeking.
Bloomberg U.S. Aggregate 1-3 Years Index is an unmanaged index that tracks bonds with 1-3 year maturities within the flagship U.S. Aggregate Bond Index.