Return Stability and Downside Protection

Short-term interest rates have been in the spotlight recently due to the Federal Reserve’s post-pandemic tightening cycle, where the policy rate has been raised a total of 500 basis points from March 2022 to May 2023.  Many dislocations in financial markets have occurred because of this interest rate shock.  Most recently, a banking crisis of confidence ensued as depositors ramped up their move out of extremely low yielding interest-bearing cash deposits and into significantly higher yielding alternatives like money market funds and short-term U.S. Treasuries.  For fixed income investors and savers, these higher levels of short-term interest rates are a welcome sign and provide income generation opportunities that were not available during the zero-interest rate policy throughout the heights of the pandemic, as shown below.  With all the competition now in the financial markets for short-duration investments, here is a review of one of those alternatives in the fixed income market.

Source: ICE BofA Current 2-Year US Treasury Index.

Short-term corporate bonds with an investment grade rating have historically provided stability and strong downside protection.  Looking at every calendar year of the ICE BofA 1-3 Year US Corporate Index since its 1976 inception, this segment of the bond market has produced a positive total return 94% of the time, as shown below.  In addition, it took the extreme conditions of the Global Financial Crisis and the aftermath of a global pandemic to generate negative total returns in only 3 of the last 47 years.

Source: ICE BofA 1-3 Year US Corporate Index.

In addition to the strong performance track record, the current valuations are attractive and offer a favorable entry point compared to any time over the last 10 years as shown below.  As of May 31, 2023, the effective yield of the ICE BofA 1-3 Year US Corporate Index was 5.48%.  Interest rates could still go higher from here given all the uncertainty surrounding the Federal Reserve’s fight against inflation and chasing yield is not a prudent investment strategy.  However, the risk/return profile of short-term corporate bonds has vastly improved, and investors can now generate more income at the current level of interest rates.

Source: ICE BofA 1-3 Year US Corporate Index. 

There are some additional risks to consider with this alternative when comparing to less risky options like U.S. Treasuries.  Corporate bonds include credit risk as well as interest rate risk, so investors must analyze if they are being compensated for the extra risk involved.  Credit risk can be evaluated by analyzing the excess returns versus similar duration government bonds.  Excess returns for the ICE BofA 1-3 Year US Corporate Index are available dating back to 1997.  This segment of the bond market has produced positive excess returns 85% of the time, as shown below.  As a result, an investor was only better off owning comparable duration 1-3 Year U.S. Treasuries in 4 of the last 26 calendar years.

Source: ICE BofA 1-3 Year US Corporate Index. 

In conclusion, the risk/return profile of short-term investment grade corporate bonds has historically been favorable for investors.  With all the uncertainty in the current macro-economic landscape and the corresponding volatility in financial markets, this segment of the bond market should be considered when evaluating the opportunity set for short-duration investments.

 

The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.  The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.