There’s nothing like ice cream on a hot day. The recent heat wave was longer than we usually get in New England, just as this year’s bond market rout seems to be dragging on. Rates and spreads have been simmering all year. But volatility creates opportunity, and this year is no exception. Since year-end, 2-year Treasury yields are up about 250bps, and 10-year rates are up 125bps. In addition to rates being higher, corporate spreads are wider, with yields on short corporate bonds rising about 300bps this year. It is not hard to find attractive investment grade bonds with 4% and even 5% yields, with select BB and B-rated high-yield issues garnering an additional 100-200bps. With short rates rising to levels equal to or higher than long-term rates, the same yield can be found with less interest rate sensitivity (duration). With rates up and spreads wider, it’s like having ice cream with hot fudge and a cherry on top!
There are many ways to take advantage of these moves in yields, depending on your favorite flavor. If you like vanilla, an old-fashioned ladder portfolio may be the simplest way to conservatively add yield. Laddered portfolios have the benefit of shortening over time. Bonds shorter than five years to maturity shrink in duration nearly one-to-one with the passage of time. Every day you wake up, your portfolio has less interest rate mark-to-market risk. Proceeds from income and maturities can be reinvested in the portfolio, held in cash, or withdrawn.
If your favorite flavor is chocolate, a defined maturity portfolio might fit. Similar to a ladder portfolio in the sense that you can lock-in and harvest today’s yields with the flexibility of directing cash flows, a defined maturity portfolio can limit interest rate risk by limiting the maturities purchased for the portfolio, for example, a 12-, 18-, or 24-month maturity maximum. An “enhanced cash” portfolio can yield 3.6-3.7% in today’s market, with a duration under a year and the longest bond maturing in under two years. Income and bond maturities can be reinvested, or allowed to roll down, providing built-in liquidity, or what might be considered a self-liquidating feature. Both laddered and defined maturity portfolios can be customized to fit specific client needs. Think of both as bond time capsules with an added benefit of flexibility if/when you need it.
Strawberry – ah, summer! A 1-3 year high-quality corporate strategy with a duration of less than two years can readily yield about 4% with about 40% each in corporates and securitized product. Liquidity is provided by the remaining ~20% in governments and ongoing cash flows provides liquidity. Bottom-up security selection drives portfolio construction, and despite the short maturities, there are many opportunities to choose from, including asset-backed securities (ABS), commercial mortgage-backed securities (CMBS), and adjustable-rate mortgage-backed securities (MBS), to corporate floaters and taxable municipals, or perhaps Treasury Inflation-Protected Securities (TIPS), or even convertible bonds. It is a rare year when a 1-3 year portfolio generates a negative total return, but indeed, 2022 year-to-date has the Bloomberg 1-3 Year Government/Credit Index down over 3%, potentially making a reasonable entry point given the longer term, more stable results of this benchmark.
When someone says governments, you might need some coffee ice cream to stay awake. Government portfolios are sleep-at-night from a credit perspective, although admittedly their interest-rate risk can cause some midnight worries in uncertain rate environments. A short government-only portfolio can be assembled with a 3.5% yield, 2.5-year duration, and an overall AAA rating. There are government ideas beyond Treasury securities, such as those issued/guaranteed by the Small Business Administration (SBA) and other government agencies where an investor can pick up 30-70bps of yield over equivalent duration Treasuries.
Salted Caramel Cookies and Cream.
For taxable investors interested in a more complex flavor, let’s call it Salted Caramel Cookies and Cream, a short crossover strategy might be of interest, with a strategic focus on after-tax relative value. The use of taxable short-maturity investment grade corporate and securitized (ABS/CMBS) issues often makes sense for taxable investors relative to tax-exempt municipals, and rotation from one sector to another can add to returns over time. Dynamic and tax-efficient allocation is designed to achieve returns in excess of pure-play (“wafer cone”) investment grade municipal bonds. Currently, tax-exempt municipals remain rich due to lack of supply; high quality short corporate and securitized bonds are more attractive on an after-tax basis. As markets move, bond relative value changes, and it is important to be able to react to new realities using a tax-sensitive, dynamic allocation strategy. A short crossover strategy is a great all-appetite vehicle for tax sensitive investors.
Richen it up with a little butterscotch (but avoid the rocky road!). For investors willing to add a bit of risk, an additional 100-200bps of yield awaits in higher-quality high yield. Crossover credit using a mix of investment grade and high-yield bonds can be an interesting alternative. A yield of 5.2-5.5% is readily achievable with a portfolio of mostly BBB and BB-rated corporates in the 1-5 year part of the yield curve, with a mid-2-year duration and an overall Ba1 rating. Of course, with high yield, principal protection is the first order of business, but the crossover credit mix typically provides more stability than a straight high yield portfolio.
Finally, for those interested in environmental, social, and governance (ESG) investing, a short portfolio of investment grade corporate and securitized issues can be put together with an emphasis on ESG leaders, a yield in the 3.7-3.8% range, and an overall rating of Aa3. There are a variety of green bonds that have been issued, though these tend to be concentrated in a few sectors like utilities and financials. Rather than a portfolio of green, social, sustainable or sustainability-linked bonds (GSS bonds), we lean on our analysts’ expertise and their evaluation of material key issues for specific sectors. We don’t necessarily exclude GSS issues, but they often have a “greenium” (a premium valuation for their label) associated with their pricing, so they have to stand on their own in relative-value terms.
The examples above are just a few of the many flavors of opportunity at the short end of the yield curve. There are of course client mandates across the curve, but recently, we have seen quite a bit of interest in shorter mandates given the available yields and flattening of the yield curve. Special orders don’t upset us, so if you want a unique sundae, feel free to order it. Sprinkles, candy toppings, whipped cream – you name it. Our business was built on customizing portfolios for our clients, and we have the systems and people in place to manage to a wide variety of guidelines. After a long stretch of near zero rates, we are again excited about today’s market opportunities, particularly at the short end and within high quality corporate and securitized sectors.
Sources: Bloomberg as of 8/16/22 unless stated otherwise. The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable but IR+M makes no guarantee as to the accuracy or completeness of the underlying third-party data used to form IR+M’s views and opinions. This report is for informational purposes only and is not intended to provide specific advice, recommendations, or projected returns for any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research + Management. “Bloomberg®” and Bloomberg Indices are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (collectively, “Bloomberg”) and have been licensed for use for certain purposes by IR+M. Bloomberg is not affiliated with IR+M, and Bloomberg does not approve, endorse, review, or recommend the products described herein. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to any IR+M product.