As the yield curve flattens and short-term rates continue to rise, investors are avidly purchasing short-term bond funds that are now yielding 2%. Although the 2% yield on fixed-income vehicles that mature in one year or less are still paltry by historical standards, the rates are the highest since the financial crisis. After a decade of a near-zero interest rate environment, these short-term yields provide comfort for investors looking for relative safety in an investment climate that has been volatile.
As evidenced by the massive inflows into short-term bond funds, investors were positively gleeful at the new higher short-term rates and have responded with alacrity. According to Morningstar, mutual and exchange-traded fund short-term bond funds rose to $174 billon in April, a record, as yield-deprived fixed-income investors flocked to take advantage of the higher rates. Over the past decade, investors interested in interest income were forced to purchase bonds with longer maturities that carried relatively meager yields.
The influx into bonds should come as no surprise. By way of example, Certificate of Deposit, long viewed as low-risk, short-term cash equivalents, never pierced the 1% barrier — a historical anomaly.
As interest rates continue to rise, bonds are starting to appear as a viable investment alternative to stocks, particularly in light of the newfound turbulence that has affected the market.
The popularity of short-term bond funds is a reaction to the current direction of the yield curve, where short-term rates are approaching the slightly higher yields on longer-term bonds. Recent concern about an uptick in inflation has also contributed to an exodus into short-term bonds as inflation erodes a long-term bond’s principal.
“The Federal Reserve zero-percent policy has hurt retirees because they can’t earn anything on their bonds or cash, so they’ve been forced to take risk they wouldn’t otherwise take on stocks or high-yield debt,” observed David Templeton, portfolio manager at Horan Capital Advisors, a Cincinnati firm managing about $350 million.
Historically, bonds with longer maturities are more sensitive to changes in interest rates than short-term debt. As the Federal Reserve has announced it will be raising rates at least twice more this year, investors are favoring shorter-term debt as the direction of the yield curve remains uncertain.
For the past 10 years, due to their relatively low yields, bonds couldn’t match the generous total returns consistently provided by the S&P 500. As the investing environment now returns to normal, the risk-reward paradigm once again will be an important and unavoidable factor in any prudent investment decision.
For years, those in retirement were forced to upend traditional conservative strategies by investing in the stock market, as bond yields were negligible and couldn’t provide a sufficient stream of income. Even though they may have carried less risk, the measly rates on bonds provided no competition to the stock market — a fact which helped propel the market to new highs during the duration of the low rate climate.
Even though junk bonds provide higher yields, the returns haven’t adjusted proportionately to the recent rise in interest rates, making them less attractive to investors who now no longer view the current yields on the lower rated bonds as adequate compensation for the level of risk assumed.
A glance at a historical chart of the yield curve will demonstrate why the investment choices for the past decade for retirees looking for low-risk income streams have been limited.
In 1979, the yield-to-maturity on government-backed Ginnie Mae certificates was approximately 13.5%. Compare this low-risk, high-yield scenario with the consistently low coupon rates carried by bonds during the past decade and one can gain some perspective on how skewed the pricing of asset classes has been.
Disclosure: I have no positions in any of the securities referenced in this article.
