As risks rise, short end can offer shelter and yield

Fast reading

The energy shock has led to one of the sharpest sell-offs in the core rates market since the Covid-19 pandemic.
The speed and size of the rate moves have briefly pushed many fixed income indices into negative total return territory.
Against this backdrop, we believe the one- to three-year part of the curve looks highly compelling.

Figure 1: Indexed total return YTD

We believe the one- to three-year part of the curve looks highly compelling.

Fixed income investors entered the year holding a few reasonable expectations:

Rate cuts were likely to continue in developed economies;
Spreads were likely to remain steady; and
Carry would likely be the main driver of returns.

Fast forward to mid-year, however, and these assumptions have been turned upside down.

The conflict in the Middle East and the subsequent surge in energy prices has led to one of the sharpest sell-offs in the core rates market since the Covid-19 pandemic.

At the time of writing, the yields on US treasuries, bunds and gilts were 40-90bps higher compared to the end of February; curves are now pricing in rate hikes across developed and developing economies.

The speed and size of the rate moves have briefly pushed most fixed income indices into negative total return territory YTD.

One exception, however, is short duration credit, where a combination of higher yields and limited duration risk has ensured that total returns have remained positive even at the worst point in March (Figure 1 shows some of the most commonly used short-duration indices with all bar one exhibiting limited drawdown in March).

Lingering uncertainties

While the longer end of the curve may potentially appear more attractive at the present time – the yield on the 30-year US treasury was just under 5% on 3 June¹, close to highs not seen since 2007 – there remain lingering uncertainties. The outlook for inflation remains clouded and highly dependent on the length of the conflict in the Middle East.

In the US, the longer end of the curve is likely to remain under pressure because of fiscal concerns, and the possibility that the Federal Reserve (the Fed) could seek to cut the size of its balance sheet under new chair Kevin Warsh. In Europe, inflation and longer-dated rates remain tightly linked to energy prices. And in the UK, political risk is likely to keep gilts volatile.

Against this backdrop, we believe the one- to three-year part of the curve looks highly compelling. In US treasuries, for example, it’s possible to lock in yields of more than 4% with a duration of just 20 months (should the yield increase another 100bps, the one-year total return would still potentially be more than 2%).

Extending into the five-to-seven-year part of the curve only adds approximately 50bps of additional yield, but duration increases by about five years. It all means that a similar move in core rates in this part of the curve would completely wipe out the total return for the year. Spread duration also materially increases, which would have an even more significant impact on total return – from further spread widening – in the event of a more severe impact on global economies from rising inflation.

To protect a portfolio and maximise total return – while generating a potential yield of more than 5% – we advocate going one step further by constructing a highly diversified global mix of securities, with a balance of corporate and sovereign commodity importers and exporters from around the world. This approach is supplemented by steady returns in investment-grade structured products, such as asset-backed and mortgage-backed securities.

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