Fixed income instruments of varying maturities have yielded next to nothing for the past 10 years. A perusal of the charts below illustrates the dearth of meaningful bond yields that have been available for income-oriented investors who were forced to purchase equities and bond surrogates to meet their investment objectives.
But the days of meager bond yields are now over. A historically unprecedented six-month surge in interest rates has now dramatically changed the fixed-income return/risk calculus.
After more than a decade of paltry, zero-interest rate fixed income returns, short-term bonds can now provide investors with a modest return and commensurate low risk. The two-year Treasury Note now carries a 4.21% rate, providing investors with a safe haven from the current turmoil that has roiled the market.
It’s difficult to believe that the two-year note was yielding just 0.21% one year ago and a miserly 1% in January.
As the yield curve charts indicate, continuous and sharp rate increases by the U.S. Federal Reserveover the past six months have decimated bond markets as prices and yields move inversely. Even though Fed Chairman Jerome Powell was adamant that the central bank will continue its regimen of rate increases sufficient to tame rampant inflation, now could be a propitious moment nonetheless to enter the short end of the bond market.
As yields rise, the price decline of bonds with longer terms is disproportionately greater than those fixed-income vehicles with lesser maturities. Longer bonds are more sensitive to interest rate changes. Given the duration risk, the inverted yield curve favors being at the short end of the maturity ranges.
With a current yield of 3.75%, the 10-year note doesn’t compensate investors adequately for the dramatic increase in maturity; and carrying a 3.7% yield, the 30-year note is even less appealing.
At 4.2%, the risk-free two-year note now provides more of an income cushion to help defray any further price declines.
The most significant issue now for bond investors is what will be the average as well as the “terminal” Federal Funds rate for the next two years. With a yield of 4.2%, the outlook for two-year notes is favorable. Additionally, some analysts believe that the bond market has already priced in a terminal rate of approximately 4.3%. If that is indeed the case, any further rate increases would have a negligible impact on prices at the short end of the yield curve.
Advantageous fixed-income rates are not confined to the Treasury market. Short-term corporate bonds also present opportunities for those seeking a safe harbor that can provide cash reserves with higher current returns than money market funds.
A review of the graphs below indicates clearly that credit spreads between risk-free Treasuries and investment grade corporates have widened dramatically over the past six months, affording investors adequate compensation for the additional default risk presented by a looming recession. Just six months ago, the risk/reward paradigm was skewed, as investors received no appreciable compensation for the additional risk assumed with lower-grade corporates.
Recently, the spread on short-term one-to-three-year investment-grade corporates was approximately 75 basis points above corresponding Treasuries, resulting in yields close to 4.5%.
Short-term ETF bond funds present an easy way for investors to participate in the superior returns available at the front-end of the yield curve. One option would be the Vanguard Short-Term Corporate Bond ETF (VCSH, Financial), an index fund covering the broad short-term corporate market. Its current yield is 4.22% with an expense ratio of 0.04%.
If the bond markets have already priced in policy tightening easing sometime early in 2023 with a terminal Federal Funds rate of approximately 4.3%, I think the yield/price dynamics for short-term bonds would make them a reasonable addition to any defensive investor’s portfolio.