In focus

Bonds are back: the opportunity in short-term fixed income

As the Fed hiking cycle has commenced, much commentary is focused on the potential weakness in fixed income markets. As is often the case, markets try to anticipate the course of future events, and this well-telegraphed move is no exception. So far this year, we have experienced a significant re-pricing of yields across the curve – most dramatically at shorter maturities. On the one hand, if markets are stable or yields drop, investors stand to earn greater returns than have been available for most of the last 10 years. On the other hand, there is now significant margin for error, or cushion, should a further adverse move in rates/credit spreads occur.

Today, the Treasury market is discounting nearly 200 bps of rate hikes over the next 12 months. In addition, corporate spreads have also undergone a dramatic re-pricing this year, touching 114 bps on the ICE BofA 1-3 Year US Corporate index, roughly 75 bps higher over the last 6 months. Therefore, the yield of a short maturity, investment grade corporate index is 2.87% as of March 15, 2022, an increase of 2.2% from one year ago.

Of course yields can always go higher still so, as ever, investment is not without risk. If markets do wind up pricing in more rate hikes, we can use the “breakeven yield” as one measure of potential downside risk. The breakeven yield is the yield to which bonds would have to rise for capital losses to offset the income earned over 12 months, resulting in a zero return. This varies by starting yield and bond maturity. As shown in Figure 1, yields for the ICE BofA 1-3 Year US Corporate index would have to rise by 1.58% from the current 2.87% yield to 4.45% - well above the last 10-year high of 3.65% - for investors to make no money.

However, after the significant repricing, the balance of risks is now much more attractive at these elevated levels. Arguably, for reasons including those below, the chances are even greater now than they were in 2018 that the Fed will not be able to complete the rate hikes the markets have priced and that investors will be able to earn more than the carry implied by current yields.

  • Growth had already been decelerating from the breakneck speed of recovery from the depths of the pandemic
  • Fiscal and monetary boosts are being withdrawn and this will weigh on the consumer
  • The erosion of real incomes from inflation looks to be sustained with ongoing energy and commodity spikes flowing from the war in Ukraine
  • Global decoupling could continue, or even escalate, creating further headwinds for economic growth

The US Multi-Sector Fixed Income team manages a variety of strategies which can help investors to take advantage of this market opportunity. The Schroder Value Short Duration strategy is ideally positioned for this environment and is now available as a sustainable strategy in a segregated account. For investors with a different focus or seeking to access other areas of the fixed income market, the team also offers slightly longer maturity options ranging from Opportunistic to Core and Core Plus, which includes the Hartford Schroders Sustainable Core Bond Fund.

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The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.