Value in short-term bonds in a rising rate environment

by Stephen Tuttle

Rate hikes

As widely anticipated, the Federal Reserve raised the Fed Funds rate by 0.25% to 0.25% – 0.50% during the March Federal Open Market Committee (FOMC) meeting. This is the first rate hike since 2018.

We think more hikes are coming, but there’s uncertainty around the speed and magnitude of rate hikes. The graph below tracks the market expectations. Note the changing expectations over the past month.

Changes in rate hike expectations

Number of .25% interest rate hikes priced in by Dec. 2022 (implied rate change/assumed rate move)

Source: BlackRock, Bloomberg, chart by iShares Investment Strategy. As of March 14, 2022. The World Interest Rate Probability data represents the estimated number of moves priced into the current forward-curve structure for the United States using the Bloomberg futures model (US0ANM DEC2022 Index).

Impact on bonds

In a rising rate environment, traditional bonds can lose value, but investors should not write off fixed income exposure altogether.

Not all bonds are the same. We believe there are attractive areas of the bond market. In particular, shorter-duration bonds can provide attractive income and are less sensitive to interest rate changes.

2-year Treasuries and corporates are attractive

The short end of the yield curve has quickly moved from basically uninvestable to attractive. The chart below shows the abrupt shift higher for the 2-year Treasury yield over the last 6 months.

The next chart shows the shift higher across the yield curve since the beginning of the year. It also shows the steepening of the short-end of the yield curve, while the overall curve has flattened, i.e. rates for Treasuries maturing 2 years or less have risen faster and farther than longer-term rates.

US Treasury Yield Curve

Source: US Department of Treasury

This creates value in the short end of the yield curve. We now see enough yield in 1- to 3-year government bonds and investment-grade corporates to add to individual bonds in portfolios.

Yields are already pricing in 8 or more rate hikes. If the Fed does continue raising rates beyond that, we will be happy to reinvest maturing bonds at higher rates in the next couple of years. In the meantime, the high-quality, short-term bonds should provide much-needed stability, diversification, and some income to balanced portfolios.

Outlook

  • We think the hawkish pricing in short-term rates might be overdone and prefer short-maturity bonds over long-term ones.   
  • We are cautious about longer-term bonds. We believe rates could grind higher based on our expectation for medium-term inflation to remain high. As such we see fewer diversification benefits to duration, with yields near lower bounds, but rising.   
  • We stay overweight US TIPS as we expect inflation to be persistent and settle at higher levels than pre-COVID. We like TIPS for interest rate exposure and diversifiers.

3 ideas for investors

  1. Enhance returns on cash 
    2-year US Treasuries now yield over 2.1%. This is a big premium over yields on savings accounts, CDs, and other cash equivalents.
  2. Tax-loss swaps
    The recent rise in rates may have generated paper losses in your intermediate- and long-term bonds and bond funds & ETFs. There might be an opportunity to harvest losses (sell) and reinvest the proceeds in short-duration individual bonds or funds/ETFs.
  3. Bond ladders 
    3-year or 5-year bond ladders are fairly attractive now. A ladder helps smooth out the effect of fluctuations in interest rates because there are bonds maturing every year.     

Signet can help you invest in a rising rate environment

To learn how to prepare for inflation and rising rates, please contact your Signet advisor, or Steve Tuttle directly at 800-390-2755 or stuttle@signetfm.com

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