How defined-maturity bond funds may help with credit market headwinds

Credit investors faced many headwinds in 2018 as financial conditions tightened, foreign demand faded, and spreads widened. Despite tailwinds from a booming economy and strong earnings growth, most credit sectors saw negative total returns. Today, many challenges remain, and the growth tailwind may be fading. But there is a certain type of fixed income strategy that can help mitigate the effects of market noise and may help investors pinpoint more attractive opportunities — defined maturity bond funds.

2018: A difficult year for credit investors

A flatter yield curve. As expected, the Federal Reserve continued to push rates higher and shrink its balance sheet in 2018. Rates on 1-year and 2-year Treasuries rose about 50% and 30% respectively, rates on 5-year and 10-year Treasuries rose about 13%, and rates on 30-year Treasuries rose about 10%.1 As shown in the chart below, this had a flattening effect on the yield curve, pushing the spread between 2-year and 10-year Treasuries to just 20 basis points to close the year — about 84% below the historical average.

What does a flatter yield curve mean to credit investors? With a flatter yield curve, there is less compensation for taking on duration risk. This has also made the short end of the curve (reflecting durations of one to three years) more attractive.

Source: Bloomberg L.P. as of Dec 31, 2018. Data from March 31, 1977, to Dec 31, 2018, from Market Matrix. US Sell 2 Year Buy 10 Year Bond Yield Spread

On the other hand, the investment grade credit curve steepened, as non-US demand for corporate bonds dropped, concerns over a global growth slowdown rose, and perceived credit risk increased. Strong US pension demand, however, did help tether the longer end as corporations capitalized on higher tax rates in 2018. Pension buying of corporates in the first half of 2018 alone accounted for four times the inflows seen in all of 2017.2

Source: Bloomberg, L.P., as of Dec. 31, 2018. The points represent the BulletShares Corporate Bond ETFs with maturity dates of 2019 through 2026

Widening spreads. In February 2018, the spread between investment grade bonds and Treasuries hit their tightest level for this cycle, and the spread between high yield bonds and Treasuries followed suit in October. However, both spreads widened with the December uptick in volatility. Investment grade spreads now sit 12% above their historical median while high yield spreads sit 6% below historical median levels (dating back to 2010).1Despite the aforementioned concerns heading into 2019, end-of-2018 spread widening has potentially made both investment grade corporate and high yield corporate bonds more attractive for investors.