After a historically poor year for the bond market in 2022, investors came into this year looking to avoid another big drawdown. Understandably, the desire to preserve capital combined with the highest short-term yields in over two decades motivated investors to flock into short duration investments, particularly T-bills and money market funds. While we understand the sentiment and see the value for a portion of a portfolio, we think now is a good time to examine the proposition more closely. Like many things in life, when something seems too good to be true, it usually is.
Thanks to elevated short-term rates, the year-to-date return for the Bloomberg U.S. Treasury Bill 1-3 Months Index through April 30 was 1.5% (4.6%, annualized). That was a solid return, particularly for such short-dated securities, but it was significantly below the year-to-date return for the Bloomberg U.S. Aggregate Bond Index (the Agg) over that same stretch, which was 3.6% (11.4%, annualized). The Agg’s outperformance was due to capital appreciation from falling yields at the long end of the curve, which of course did not benefit T-bills as they have nearly zero duration. In fact, as we discuss below, falling short-term rates have essentially the opposite effect on short duration bonds.
Reinvestment Risk is the Primary Challenge
One of the key objectives of a fixed income allocation is to prepare for specific future funding needs: providing a pension for employees, building a factory, saving for retirement/education, etc. Given that most investors have multi-year (or multi-decade) time horizons, investing in 1-month T-bills and other short-dated assets creates an obvious mismatch. We recently experienced the real-world consequences of getting it wrong – albeit in the other direction – when several banks failed because their assets (U.S. Treasuries and mortgage-backed securities) had a much longer duration than their liabilities (overnight deposits).
As you can see below in the Reinvestment Risk column of the heat map below, each of the major investment grade sectors is sensitive to this risk factor. The problem is that every time a short-term bond matures, the proceeds must be reinvested at the prevailing interest rate.
For example, when the year began, the 1-month T-bill (a zero-coupon bond that is sold at a discount) yielded roughly 4.0%, annualized. However, to realize that 4% return, you would need to buy the 1-month bill at 99.67 and redeem it at par every month for 12 months. It is easy to see the reinvestment risk inherent in this approach over a long time horizon. Eventually the fed funds rate will come down from its current level, and so too will the returns of T-bills.
T-Bills Erode Purchasing Power
Another issue with overweighting T-bills is that it is difficult to beat inflation, the silent killer of purchasing power in a portfolio. In 2023, the annualized yield of the 1-month Treasury bill has only beaten the monthly release of the year-over-year change in CPI (excluding Food and Energy) once.
As you can see from the above table, the investor rolling T-bills has lost to inflation by an average of 104 basis points (1.04%) this year on an annualized basis. In addition, as the chart below shows, the cumulative returns for 3-month T-bills have lagged cumulative CPI since 2000.
Capital Appreciation is More Impactful Than Income
As the April year-to-date returns on the Agg demonstrated, under the right circumstances, capital appreciation can have a much larger impact on returns than the interest a bond pays. Consider that at the start of the year, the yield on the T-bill index was actually higher than the Agg. In other words, if interest rates had not changed during the period, and returns were entirely determined by the coupon each investor received, the T-bill index would have materially outperformed the Agg. However, because the Agg contains a mix of short and long-term bonds, it benefitted from falling rates, which is why it delivered such strong returns.
Portfolios that are heavily concentrated in short duration securities such as T-bills and money market funds are unable to benefit from this situation. Of course, the opposite is true, so it is important to deploy duration when interest rates are more likely to fall than to increase. In our view, now is a good time to start adding duration, as there are three key economic indicators that suggest rates are going to continue falling over the near to medium term: the shape of the yield curve, the direction of inflation, and recent comments from the Fed.
What is the Yield Curve Telling Us?
Regarding the inverted yield curve, there has been no lack of discussion of the implications of the shape as a predictor of a coming recession (which is not necessarily the case, as we have argued before). However, what is generally less appreciated is that an inverted curve mathematically predicts expected lower interest rates in the future.
Of course, the question of when that will actually happen is largely driven by the Fed, which takes its cues from changes in inflation. The curve has been inverted for over a year now, but for much of that time inflation was still increasing and the Fed was still raising rates.
But for the past few months, inflation has finally settled into a cooling trend (though it remains well above the Fed’s 2% target), opening the door for the Fed to stop hiking rates, which they hinted at during their last meeting.
When we look at all of these factors together, plus what we have already observed in 2023, we come away convinced that rates are likely past their near-term peak, which means now is a good time to add duration and take advantage of the capital appreciation that should present itself in the near future.
To put a finer point on this opportunity, one year after the end of the past three hiking cycles by the Fed (2000, 2006, and 2018), the fed funds rate fell by an average of 108 basis points and the yield on the 10-year Treasury fell by an average of 65 basis points. If the same thing were to happen this time, 1-month Treasuries would see their returns fall by roughly 1%, while 10-year Treasuries would generate a gain of over 5.6% due to capital appreciation (assuming a 3.375% coupon), generating a total return of ~8.9%.
Duration Performs Well in Uncertain Markets
Another reason we feel it is prudent to diversify out of short-term bonds (which we discussed in our latest quarterly outlook) is that a long duration position typically is the primary beneficiary of a shock to the risk markets. We saw this most recently when yields fell to generational lows during the onset of the Covid lockdowns. Other periods of disruption in the market, such as the Great Financial Crisis, September 11th, the 1987 stock market crash, etc., all saw substantial positive returns generated from a long duration position.
While it is nearly impossible to anticipate the next exogenous shock to the market, it seems as though the list of events that could spark a flight to quality grows by the day.
Final Thoughts
While we believe an allocation to short-term bonds makes sense for a portion of a portfolio, particularly assets that are earmarked for near-term expenses, we do not think it makes sense for the majority of fixed income assets, which are generally used to fund retirement portfolios. We firmly believe that inflation has peaked and will continue to fall, which will allow the Fed to cease hiking and eventually begin cutting rates, leading to long duration positions outperforming short maturity bonds.
John Sheehan
Prior to joining Osterweis Capital Management in 2018, John Sheehan spent more than 20 years working at Citigroup, first as Managing Director responsible for Investment Grade Syndicate in New York City, where he advised issuers on accessing funding in the corporate bond market. Later at Citigroup, he was Managing Director in charge of West Coast Investment Grade Sales in San Francisco, where he covered several of the largest U.S. investment grade credit investors.
He is a principal of the firm and a Portfolio Manager for the total return fixed income strategy.
Mr. Sheehan graduated from Georgetown University (B.A. in Economics). Mr. Sheehan holds the CFA designation.
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