Fixed income instruments of various maturities have yielded next to nothing over the past 10 years. A reading of the charts below illustrates the lack of meaningful bond yields available to income-oriented investors who have been forced to buy stocks and bond substitutes to meet their investment goals.
But the days of low bond yields are now over. An unprecedented six-month spike in interest rates dramatically changed the risk/return calculus of fixed income securities.
After more than a decade of paltry zero-rate fixed-income returns, short-term bonds can now offer investors a modest return and low commensurate risk. The two-year Treasury note now bears a rate of 4.21%, providing investors with a safe haven from the current turmoil that has rocked the market.
It’s hard to believe that the two-year note was yielding just 0.21% a year ago and a paltry 1% in January.
As the yield curve charts indicate, the US Federal Reserve’s continued and steep rate hikes over the past six months have decimated bond markets, with prices and yields moving in opposite directions. Even though Fed Chairman Jerome Powell was adamant that the central bank would continue its regime of rate hikes sufficient to rein in runaway inflation, the time could still be right to enter the short end of the bond market. .
As yields rise, the decline in prices for longer-term bonds is disproportionately greater than for fixed-income vehicles with shorter maturities. Longer bonds are more sensitive to changes in interest rates. Given the duration risk, the inverted yield curve favors a position at the short end of the maturity ranges.
With a current yield of 3.75%, the 10-year note does not sufficiently compensate investors for the dramatic increase in maturity; and bearing a yield of 3.7%, the 30-year note is even less attractive.
At 4.2%, the risk-free two-year note now provides more of an income cushion to help cover any further price declines.
The most important issue currently for bond investors is what the average rate will be as well as the “terminal” rate of the federal funds for the next two years. With a yield of 4.2%, the outlook for two-year bonds is favourable. Moreover, some analysts estimate that the bond market has already priced in a terminal rate of around 4.3%. If this is indeed the case, any further rate hikes would have negligible impact on prices at the short end of the yield curve.
The advantageous rates of fixed income securities are not limited to the Treasury market. Short-term corporate bonds also present opportunities for those seeking a safe harbor that can provide cash reserves with higher current yields than money market funds.
A review of the charts below clearly indicates that credit spreads between risk-free Treasuries and higher quality corporates have widened significantly over the past six months, providing investors with adequate compensation for the additional default risk. presented by an impending recession. Just six months ago, the risk/reward paradigm was skewed, with investors receiving no meaningful compensation for the additional risk taken on with lesser quality companies.
Recently, the spread on one- to three-year short-term investment-grade corporate bonds was about 75 basis points above corresponding Treasuries, resulting in yields close to 4, 5%.
Short-term ETF bond funds offer investors an easy way to participate in the higher yields available at the start of the yield curve. One option would be the Vanguard Short-Term Corporate Bond ETF (VCSH, Financial), an index fund covering the entire short-term corporate market. Its current yield is 4.22% with a spend rate of 0.04%.
For individual issues, investors can consider Home Depot shares (HD, Financial) 2025 Bond with a YTM (Yield-to-Maturity) of 4.25%.
If bond markets have already priced in policy easing in early 2023 with a terminal fed funds rate of around 4.3%, I think the yield/price dynamics of short-term bonds would make this a reasonable addition to the portfolio. of any defensive investor.