Get Shorty: Finding Opportunity in the Front of the Curve
The year so far has been painful for fixed income investors. The rise of around 70bp in the US 10Y Treasury yield has proved a major drag on most fixed income assets. Moreover, it is by no means clear that the sell-off has finished. During the first 3 phases of US quantitative easing (QE) there were three aggressive bond sell-offs that, on average, lasted 21 weeks and saw a rise in the 10Y Treasury yield of 140bp.
With central banks already heavily embedded in financial markets, they may see reason to push back against anything that starts to resemble a bond rout. However, it may still be prudent for investors to assume more defensive bond positions at the shorter part of the curve. In the current environment, we see three reasons to like the front of the curve:
1. Central banks remain a long way from raising rates.
The US Federal Reserve (Fed) took 7 years to make its first rate move following the Global Financial Crisis and the tightening process was gradual. Yet the Overnight Index Swaps market currently prices 50bp of tightening in 2 years and 100bp 3 years forward. In short, the market has already priced a pretty aggressive policy tightening for a central bank that has clearly downplayed fears over inflation. This should limit the ability of the front end to sell off further, even on robust economic numbers, thus protecting shorter-dated bonds.
2. Shortening duration risk.
Reducing a portfolio’s price sensitivity to rising yields is a key defensive strategy for fixed income investors. Low yields and, until recently, flat curves have seen debt management agencies skew issuance towards longer bonds. This, along with the shift lower in yields, has seen the duration of bond indices lengthen. For example, the duration of the Bloomberg Barclays Euro Aggregate: Treasury Index has extended by 1.4 years during the last 5 years. Over that time period, the ratio of price sensitivity versus the shorter Bloomberg Barclays Euro Aggregate: Treasury 1-3 Year Index has moved from 3.8 to 4.5 times. Carrying this extra duration can be expensive in a rising yield environment, which makes strategies that shift into the shorter part of the curve to reduce duration exposure more appealing.
3. The sell-off has restored some yield.
A key argument against investing in the short part of the curve has been that it is not just a low yield, but a no yield environment. However, the recent sell-off has restored some value to the short end.
One of the more extreme moves has been at the front end of the gilt curve where the vaccination push has raised hopes of an early return to something that resembles normality for the UK economy. As a result, the Bloomberg Barclays UK Gilt 1-5 Year Index has moved from a yield of -10bp at the start of the year to +15bp currently. That is not a great deal in outright terms, but it represents a meaningful pick-up to the 5bp on offer from the SONIA overnight rate. The overnight rate represents the typical rate that is paid on money held at banks, so this is a clear example of where short-dated funds can be used to reduce the impact of ‘cash drag’ on portfolios.
Go defensive while seeking yield enhancement
Short-maturity bonds are a defensive strategy for the current reflationary environment but they can also be yield-enhancing. The chart below shows the yield to worst on certain key short-maturity indices and how that relates to duration risk.
The Bloomberg Barclays US High yield 0-5 Year (ex 144A) Index and the ICE BoA 0-5 Year Emerging Market USD Index stand out as providing a high yield versus a relatively low duration. Obviously, these indices have very different risk characteristics to those of investment grade exposures, but the higher yields also provide protection to rising underlying yields. US high yield in particular, with an option-adjusted duration of 1.84 and a yield of 3.73%, can endure around a 200bp sell-off before the price losses on the underlying position offset the coupon.
Indeed, high yield is one of the few fixed income strategies to have posted positive returns year to date, partly driven by investor demand for the yield but also because the strong reflationary backdrop should ultimately support an improvement in the credit quality of the bonds.
