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Steering Away From Volatile Markets: Short‑Term Bonds May Offer Value As Fed Eases

Short-term bonds could rise in price and potentially maintain a high degree of liquidity in response to Federal Reserve rate cuts.

Market volatility in August and September created one of the bumpiest rides for investors since the financial crisis. With lingering uncertainties over trade and economic growth, volatility is likely to persist, and investors are responding by reducing portfolio risk.

Many turned to money market funds to wait out market volatility. At today’s low yields, however, that could have a significant effect on longer-term portfolio returns: Historically, during similar periods, many investors stayed in money market funds for much longer than a few months – typically for two years or more.

Investors who can tolerate a modest step up in risk may find an attractive alternative in high quality short-term bonds. We think short-term bonds are likely to perform well in the coming months.

Autopilot allocations

For decades, investors have turned to regulated money market funds when shifting to defense, and this time is no different. After the volatile fourth quarter in 2018, money market assets have increased by more than $350 billion this year and surpassed $3 trillion by the end of August, according to the Investment Company Institute.

If history is any guide, money market assets could remain elevated for some time. As Figure 1 shows, government money market assets increased during past Fed rate-cut cycles – and remained elevated for 18–24 months after the rate cuts ended.

Steering Away From Volatile Markets: Short-Term Bonds May Offer Value As Fed Eases

While money market funds generally do a good job of preserving capital and offer daily liquidity, there is an opportunity cost: low net yields versus the fed funds rate. Most recently, the average current money market fund yield was 1.70%, below the current fed funds target rate of 1.75%–2.0% (as of 20 September 2019).

Avoiding stalling while de-risking

Strategies that invest in short-term bonds may provide a structural return advantage above money market yields because they have greater flexibility to invest in higher-yielding securities outside the regulated money market universe of U.S. Treasury bills and short-term government securities. These strategies typically include bonds with slightly longer maturities and moderately higher credit risk. With this flexibility, actively managed short-term strategies seek higher yields and the potential for capital appreciation.

Currently, short-term bonds could rise in price and potentially maintain a high degree of liquidity in response to Fed rate cuts. Following the Fed’s easing in July and September, we expect further easing before year-end and into 2020 as the Fed responds to continuing economic uncertainties.

We analyzed the performance of money market funds versus an index that is a proxy for many short-term bond strategies, three-month LIBOR, during previous Fed rate-cutting cycles. In general, as policy rate cuts commenced, three-month LIBOR outperformed the average money-market fund slightly, and as the easing cycles lengthened, LIBOR outperformed more significantly (see Figure 2).

Steering Away From Volatile Markets: Short-Term Bonds May Offer Value As Fed Eases 

By definition, actively managed short-term strategies aim to generate higher returns than their benchmark indices, such as three-month LIBOR. Because investors in short-term strategies have the potential to earn a structural premium, there is a potential opportunity cost when investors remain on the sidelines for an extended period of time.

Minimizing road hazards

Maximizing return in today’s low-yield environment becomes more important when taking into account the potential for higher inflation. As the Fed eases to stimulate growth and trade tariffs take hold, U.S. inflation could rise. Money market yields below inflation rates could be a hidden hazard for investors looking to preserve capital, manage liquidity, and protect their purchasing power.

The bottom line? When investing defensively, it is possible to slow down without slamming on the brakes: Strategies that invest in short-term bonds can help investors reduce portfolio volatility without giving up the prospect of attractive risk-adjusted returns.

For more on short-term markets, see “Repo Rate Spike: A ‘Tail’ of Low Liquidity.

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Jerome Schneider is a managing director and PIMCO’s head of short-term portfolio management. 

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Jerome M. Schneider

Head of Short-Term Portfolio Management

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Short-term investments will be more volatile than money market funds and their value will fluctuate. The investments may also invest a portion of their total assets in junk bonds. Short-term strategies are not federally guaranteed and may lose value.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice. Investors should consult their investment professional prior to making an investment decision.

 

Repo Rate Spike: A ‘Tail’ Of Low Liquidity
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