Bond market dilemma: Lowering duration without sacrificing yield

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[ "Edward Kerschner", "Ronald Stahl, CFA", "Neeraj Agarwal" ]
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Fixed-income investors limit their opportunity set when they focus on benchmark-tracking or benchmark-hugging strategies. But many investors do it anyway.

Investors faced with macroeconomic and capital market uncertainties have been moving into short-duration fixed-income solutions. Dominated by shorter all corporate or government/corporate debt, these solutions offer little diversification by sector, credit quality or country allocation — where wider spreads and higher yields are often found.


Traditional benchmarks like the Bloomberg U.S. Aggregate Bond Index and the Bloomberg Short-Term U.S. Aggregate Bond Index have delivered annualized returns of 4.9% and 3.8% since 2000, respectively. But these benchmarks have changed their composition pretty significantly since the Great Recession. The Agg’s weight in Treasury securities ballooned, corporate and securitized exposure in the index shrank, and the benchmark extended duration and lowered yield as a result. While duration for the Short-Term Agg is relatively constant, yields are currently very low. Meanwhile, the duration of the Agg is at its peak since 2000. Longer duration means greater risk of price declines if rates rise even modestly.


Line chart showing a decline in yields for the Agg since the year 2000 while duration has increased over the same period, and a similar decline in yields for the Short Term Agg with steady duration.


The constituents in the Morningstar Short-Term Bond category overwhelmingly use versions of shorter all-corporate or government/corporate indices — offering little diversification by sector, credit quality or country allocation — where wider spreads and higher yields are often found. Not surprisingly, the Short-Term Agg has a 99% correlation to the Bloomberg 1–5 Year Government/Credit Index, one of most frequently used indices in the category.1


Better return due to sourcing better income opportunities

Investors could benefit from owning lower duration, diversified fixed-income solutions that invest in higher income-producing sectors, such as high-quality high yield, emerging market debt and broad use of structured assets. Together, with investment-grade corporate bonds, these sectors typically experience low correlation and can provide attractive income and capital appreciation, while keeping overall duration reasonably low.


Bottom line

The short end of the yield curve is often referred to as the “sweet spot,” where investors can typically find the most attractive risk-reward profiles. Today, investors need to consider an approach that allows them to remain invested in key sectors that can generate income while also navigating the uncertainty of interest rate moves and market volatility.


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