While the Federal Reserve’s (Fed’s) significant policy tightening in 2022 has contributed to negative total returns across asset classes, going forward, we believe the risk-reward in short duration fixed income could be very favorable for new investors. Yields have risen across the entire yield curve, yet front-end maturities, with their inherently lower price volatility profile, are now uniquely positioned to potentially offer substantial downside protection against a further, unexpected rise in Treasury yields. We conclude that the probability of very short tenors returning positive total returns is now very high, particularly over a 12-month horizon.
Below we show several interest rate simulations on two investment strategies: The first represents a new investment in a target 6-month duration government portfolio and the second represents a new investment in a 1–3 year government/credit strategy. If the current level of Fed policy is not sufficient for reducing the level of inflation in the domestic economy and instead the federal funds rate needs to rise to 6% from the current expectation of 5%, our model shows that the 6-month government portfolio should still return 4.68% over a 12-month period while the 1–3 year government/credit portfolio should return 2.87%. In both situations, our model shows the level of income would be more than enough to offset the price decline well in excess of what is shown below, and the probability of a positive total return on net investments over that time horizon becomes very likely.
Hypothetical and past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Through the November 2 Federal Open Market Committee (FOMC) meeting, the Fed has raised the overnight borrowing rate by 3.75% year to date. There is another FOMC meeting to come in mid-December, and the market is projecting that the terminal value will end up just above 5% in mid-2023. A variety of inflation measures, including the Personal Consumption Expenditures Index (PCE; core PCE was 5.1% in September) and the year-over-year change in average hourly earnings (4.7% in October) indicates that 5% seems to be the approximate level of inflation in the economy and therefore an appropriate level of overnight interest rates.
Following the overnight rate, over the past year, the 2-year Treasury note yield has increased by 3.98% to 4.48%—the highest level since 2007.
In addition to higher yields, concerns regarding if and when a recession might be coming have caused investors to demand a higher level of compensation for lending to corporations. The ICE BofA U.S. Corporate 1–3 Year Index offers a spread of 112 basis points (bps; 100 bps equal 1.00%), which is 80 bps higher over the past year and 41 bps above the 5-year average. The index offered an all-in yield of 5.67% as of October 31, while many individual securities can be purchased at a yield in excess of 6.00%.
As you can see, the level of income now available across asset classes and strategies may help insulate portfolios from any unexpected need to raise interest rates above what is already priced into the market.
Within the broader Global Liquidity Solutions team, the short duration portfolio management team offers highly customized solutions for a wide range of client types with a focus on preservation of principal, constructing portfolios with a high degree of liquidity, and earning a competitive risk-adjusted return for our clients. The team has deep, experienced resources, including significant utilization of the Global Fixed Income Research platform. It takes a multi-sector approach to actively manage risks and works as extension of your staff to understand your risk tolerance, cash flow needs, and other considerations.
Disclosure
The Personal Consumption Expenditures (PCE) Price Index reflects changes in the prices of goods and services purchased by consumers in the U.S. It is part of the Personal Income and Outlays Report issued by the Bureau of Economic Analysis of the U.S. Department of Commerce. You cannot invest directly in an index.
The ICE BofAML U.S. Corporate 1-3 Year Index tracks the performance of U.S. dollar-denominated investment-grade rated corporate debt publically issued in the U.S. domestic market with a remaining term to maturity of less than 3 years. You cannot invest directly in an index. Copyright 2020. ICE Data Indices, LLC. All rights reserved. Copyright 2022. ICE Data Indices, LLC. All rights reserved.
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