It’s a good time to buy short-term bonds
Until recently, short-term bonds were a wasteland of yield: a two-year Treasury bill yielded 0.21% a year ago and just 1% in January. Today, the yield is above 3.8% and could soon touch 4%, thanks in large part to the Federal Reserve’s aggressive interest rate hike campaign.
The work of the Fed, which is trying to calm the economy and rein in persistently high inflation, is not about to end. Rates are expected to continue to rise in early 2023. Typically, this would put pressure on bond prices, which move inversely to yields.
But this could be a good entry point for short-dated bonds: they may not fall much further and yields are now high enough to withstand some price pressure. “We’re actually comfortable owning the beginning of the yield curve here,” says Bob Miller, head of Americas fundamental fixed income at BlackRock.
Granted, it’s a wacky time for bonds. The yield curve is now inverted: most short-term bonds yield more than long-term bonds, such as 30-year Treasury bills at 3.47%. The result is that investors are not compensated for holding long-term bonds. Quite the contrary: yields are lower and duration risk (or interest rate sensitivity) is higher in the long term.
Short-term funds have accumulated losses this year. The iShares 1-3 Year Treasury Bond exchange-traded fund (ticker: SHY), a proxy for Treasury bonds, is down 3.85%, after interest.
Still, some analysts think short-term yields could now be close to prices in the rest of the Fed’s rate hikes. With yields close to 4%, there is much more of an income cushion against price declines. Investors can also reap slightly more income than with cash proxies like money market funds, which currently yield around 2%.
“When you have a 3.75% yield, it’s a lot more manageable,” says Cary Fitzgerald, head of short-term fixed income at JP Morgan Asset Management.
The remaining risk is the “terminal” federal funds rate – the point at which the Fed suspends hikes.
Currently in a range of 2.25% to 2.5%, the fed funds rate should rise sharply from here. The futures market sees a 75% chance of a three-quarter point rise when Fed officials meet next week. Another rate hike is expected in November, bringing the rate to around 4% in December.
The futures market expects the fed funds rate to peak at 4.4% in the first quarter, following a much higher-than-expected consumer price inflation reading in August.
Terminal rates of 4.75% or even 5% are not impossible, however, under a range of scenarios: inflation remains high, the war in Ukraine continues to disrupt energy prices, or supply does not return to normal, exerting more upward pressure on prices. “Really, it’s a question of what the average federal funds rate will be for the next two years,” Fitzgerald says.
The bond calculation looks favorable to short-term notes. Over a two-year duration, for example, the two-year Treasury would lose 40 basis points, or 0.4% in price, for another 20 basis point rate hike by the Fed. (A basis point is equal to 1/100th of a percentage point.) Even if the Fed were to raise rates another 175 basis points, bonds could generate positive returns throughout their lifetime.
Inflation data is unpredictable, of course, but some bond managers say the market has largely priced in a federal funds terminal rate. BlackRock’s Miller thinks the two-year Treasury yield is priced in to peak at around 4.3% in the first quarter of 2023. “The two-year note looks like a reasonable asset,” he says. “Is it really cheap? No. But it’s not as ridiculously rich as it was a year ago.
Tom Tzitzouris, head of fixed income research at Strategas, says short-term yields are also terminal. If that’s the case, he adds, “you’re basically going to cut your coupons into two-year Treasury bills because the market has already priced in the tightening.”
Opportunities in shorter term bonds are not limited to Treasuries. John Bellows, portfolio manager at Western Asset Management, likes high-quality corporate debt, which has both a yield component and some income from the credit risk embedded in the bonds.
“We have a widening of credit spreads at the very beginning of the curve,” he says. The spread on investment grade three-year corporate bonds was recently around 75 basis points over corresponding Treasuries, putting yields around 4.5%. “Over a three-year period, there’s a lot of total return potential,” he says.
Mark Freeman, chief investment officer at Socorro Asset Management, also likes short-term corporate debt. “With risk-free rates around 3.75% and high-quality corporate bonds yielding between 4.25% and 4.75%, it’s not a bad place to be. find in a volatile investment environment,” he says.
Various mutual funds and ETFs provide exposure to the shorter end of the yield curve. For pure treasuries, the $26 billion iShares 1-3 Year Treasury Bond ETF offers broad diversification at a low price. It has an SEC yield of 3.31% and an expense ratio of 0.15%.
For corporate bond exposure, consider the $43 billion
Vanguard Short Term Corporate Bonds
ETF (VCSH), an index fund covering the entire market. It sports an SEC yield of 4.22% and an expense ratio of 0.04%. The fund is down 5.85% this year, after interest payments, lagging 78% of its peers. But its razor-thin spend ratio has helped it edge nearly 90% of its rivals over the past 10 years, according to Morningstar. His holdings as of July 31 included debt securities issued by blue chip companies such as
Bank of America
Goldman Sachs Group
Among the high-quality, short-term bonds that Freeman holds in his clients’ portfolios is one issued by
(HD) which matures in 2025 and has a yield to maturity of 4.25%. Freeman cites the retailer’s “dominant market share, loyal customer base and forward-thinking management team.”
Also in his wallet is a
(PSX) with a yield to maturity of 4.5%, and a bond issued by
(TGT) maturing in 2025 with an actuarial yield of 4.2%.
Assuming the Fed doesn’t get much more hawkish, this rate cycle should run out of steam in six months or less. As these returns show, the short end of the curve does not always match the short end of the stick.
Write to Lawrence C. Strauss at [email protected]