The bond market is now offering investors a sweet deal, with short to intermediate maturities providing a good combination of risk and reward.
When interest rates rise, bond prices fall. The longer the maturity of a bond, the more sensitive its market value will be to changes in interest rates.
This means that as the Federal Reserve continues to raise interest rates to clamp down on inflation, bond portfolios with shorter maturities will be safer day-to-day.
And the inverted yield curve, with two-year U.S. Treasury notes
yielding more than 10-year notes
underscores the opportunity investors have to earn higher yields while taking less risk than they would with longer-term bonds.
Jim Dadura, director of fixed income at Segall Bryant & Hamill in Chicago, which has about $21 billion in assets under management in mutual funds and private and institutional accounts, dug into some of the technical factors underlining how attractive the intermediate maturities are today.
With bonds, the time to make a move is now
During the long period of historically low interest rates and a rapidly increasing money supply through 2021, the obvious place for investors seeking growth or income was the stock market. But we are in a different environment now, following aggressive moves by the Federal Reserve to raise interest rates.
Whether to have exposure to bonds (which might include the classic portfolio mix of 60% stocks and 40% bonds) can be a complicated decision, based on your investment objectives, the timing of a possible refocus to income rather than long-term growth and your retirement plans.
But you also need to consider what the financial markets are giving you.
BlackRock CEO Larry Fink summed up the new paradigm for investors considering their balance of stocks and bonds, which was shared in a Twitter posting on Oct. 19:
Lewis Altfest, co-founder of Altfest Personal Wealth Management, which is based in New York and manages about $1.5 billion in private accounts, said his clients were “just starting to get interested” in bonds again.
“Keep in mind that there is a big plus and a big minus in their heads — not mine. The big plus is the yields you can squeeze out now — they are tangible. The negative is they have taken a hit on what they have had in their portfolios,” he said.
Altfest added that stocks and bonds have fallen by similar degrees, broadly, in 2022. This implies that investors shouldn’t necessarily shy away from selling some stocks to make a move into bonds.
Inverted yield curve and duration risk
“Today we are seeing some healing in the market, particularly at the short end of the yield curve,” Dadura, of Segall Bryant & Hamill, said during an interview.
He provided this chart showing the yield and duration of the Bloomberg U.S. Government Credit 1-3 Year Index and associated risk factors as of Sept. 30:
Segall Bryant & Hamil, using data provided by Bloomberg.
You can read Segall Bryant & Hamill’s full explanation of the chart here.
As of Sept. 20, the yield on the Bloomberg U.S. Government Credit 1-3 Year Index was 4.21%, while its average duration was 1.90 years.
The duration of a bond portfolio is a measure of its volatility. The duration number indicates what the percentage change in market value that can be expected for every 1% move up or down for interest rates.
In the table below the chart, you can see the “cushion” that Dadura described. If interest rates were to move up 1% from here, a portfolio modeled on the Bloomberg U.S. Government Credit 1-3 Year Index would be expected to decline in value by 1.9%. But the yield of 4.21% would provide a cushion. A year earlier, the index was yielding only 0.39%.
And yields have risen since the end of September, with two-year Treasury notes yielding 4.25% at the end of the day on Oct. 25, while 10-year Treasury notes were yielding 4.10%.
A portfolio with a similar maturity in the current environment offers a good combination of risk and reward. Based on figures at the end of the day on Oct. 25, the Bloomberg U.S. Government 10-15-Year Index had a duration of about 9.9 and a yield to maturity of 4.40%, pointing to a market-value decline of close to 10% if long-term rates were to rise 1% from here, with a dividend-yield cushion of less than half that amount.
Summing up the current scenario for bond investors, Dadura said “you do not have to take a lot of risk, with more yield than duration” in shorter-term bonds.
“This is very attractive, a place where investors can hide out,” he said.
The inverted yield curve, with 10-year Treasury notes yielding less than 2-year notes, indicates expectations of a recession because enough bond investors see interest rates falling as the Fed reacts to an eventual economic slowdown. Since long-term bonds are so much more sensitive to interest rates, investors holding them would enjoy large gains in market value.
But many investors don’t want to take that risk and suffer so much higher day-to-day volatility while they wait, possibly for years, for interest rates to plunge.
There are many ways for investors to earn income in the bond market. If you hold your own bonds, an investment adviser can help you set up a portfolio of varying maturities to take best advantage of the relatively high interest rates on shorter-term bonds and incorporate your risk tolerance.
Holding your own bonds until maturity means that as long as you are not forced to sell in a down market, you have the surety of knowing how much you will be paid when your bonds mature.
If you hold U.S. Treasury paper, the interest is exempt from state and local taxes. That might be meaningful depending on your tax rates. You can calculate your own fully taxable equivalent yield by dividing the yield by 1, less your highest combined state and local graduated income tax rate.
For example, 2-year U.S. Treasury notes yielded 4.42% on Oct. 25. If you are married and living in New York City, with combined earnings between $161,551 to $323,200, your highest state graduated tax rate is 6.33%, plus another 3.876% for city income taxes, according to NerdWallet. That’s a combined state and city tax rate of 10.206%. The 4.42% 2-year Treasury yield divided by 0.898 gives you a taxable equivalent yield of 4.92%.
Dadura co-manages the Segall Bryant & Hamill Short Term Plus Fund
which mainly holds investment-grade short-term corporate bonds. It is rated four stars (out of five) by Morningstar and had an effective duration of only 1.2 years as of Sept 30.
The fund’s 30-day SEC yield of was 4.03% on its institutional shares and 3.90% on its retail shares
as of Sept. 30. The 30-day yield is an industry standard that express the yield over the past 30 days annualized to the current share price.
Those yields are after expenses, which are 0.40% of assets annually for the institutional shares and 0.49% for the retail shares, after fee waivers. Morningstar considers the expense ratio to be “below average” for the institutional shares and “average” for the retail shares. The institutional shares may be available to you, depending on the relationship between your investment adviser or broker and Segall Bryant & Hamill. The fund has only $33 million in assets, but Dadura and colleagues run a total of about $614 million under the strategy.
You can also take advantage of the “yield cushion” that Dadura described, with an exchange traded fund that tracks one of the shorter-term or intermediate-term bond indexes. There are many; here are four examples, with all data as of Oct. 24:
The SPDR Portfolio Short Term Treasury ETF
has a 30-day yield of 4.39%, with an option-adjusted duration of 1.8 years. The fund’s annual expenses are 0.06% of assets under management and it is rated four stars by Morningstar. This is an easy way to focus on the 2-year Treasury market.
For less risk even than SPTS, you might go with the iShares Short Treasury Bond ETF SHV, which had a duration of only 0.3 year with a 30-day yield of 3.20%. The fund’s expense ratio is 0.15% and it has a thee-star rating from Morningstar.
If you are willing to take more volatility risk in pursuit of a higher yield, the iShares Core 1-5 Year USD Bond ETF
might fit the bill, with a 30-day yield of 4.88% and an effective duration of 2.7 years. The fund is 47% invested in U.S. Treasury obligations. Its expense ratio is 0.06% and it has a three-star rating from Morningstar.
You might also decide to take a bit more credit risk for an even higher yield. The iShares 1-5 Year Investment Grade Corporate Bond ETF
had a 30-day yield of 5.51% with an effective duration of 2.7 years as of Oct. 24. The fund’s expense ratio is 0.06% and it has a three-star rating from Morningstar.