The front end of the yield curve remains bolstered, despite signs that the end of a near-zero Fed funds rate is on the horizon. Cash continues to flow to shorter duration maturities for a number of reasons. Large corporate cash positions, excess bank liquidity, investors moving out of cash to pick up yield, and investors moving down the curve to reduce duration risk have all led to a steep front end of the curve. This is even more pronounced in the tax-exempt market, where municipal/Treasury ratios are near the lows of the last year. However investors who have sought out short duration investments may be unpleasantly surprised when these investments do not perform as expected.
A look at the futures market tells us that the market is expecting that the next move in rates will be a bear flattener – short term rates will move up more sharply than long term rates. This makes sense, given that short term rates have been anchored by the Fed’s easy money policies, and the yield curve has steepened over the last year. Yet, there’s no reason to expect that the Fed will keep the funds rate near zero indefinitely; real rates remain negative at the short end of the curve, so a 2-year note at 150 basis points would still be accommodative.
But a bear flattener may bring unexpected consequences. Many investors, particularly retail investors, have moved out of CDs or cash into shorter duration securities in an attempt to pick up yield. These investors may be surprised when what they thought was a money market substitute instead turns out to be an investment with duration risk and potentially negative returns. Likewise, investors who sought to limit risk by shortening duration have done so at the expense of yield. When short rates rise, it’s possible that negative price returns will outrun these low yields, making that ‘riskless’ transaction look fairly risky. Meanwhile, investments in the intermediate part of the curve (ten to fifteen years) offer significantly more yield, with potentially less price erosion. Andrew Norelli wrote about the impact of carry on bond returns in his blog, ‘Yield Hogs Unite’ on April 10. The attached chart looks at the potential one year return from investments across the curve using the current futures market as a reference for rates one year forward, and while it doesn’t show losses for short duration investments, investors must hold for the entire year just to recoup a near-term negative.
Historically, intermediate maturity fixed income investments have offered the best combination of duration risk and return. But many argue that the bull market of the past thirty-two years has masked the true risk of bond investing, and that when rates rise, longer duration investments will experience continual losses. That notion, however, ignores the fact that bonds mature, and that as bonds move towards maturity, their prices revert back to par. It also ignores the impact of coupon reinvestment at higher rates. Over the longer term, investors need to be aware of the role that yield plays in the face of an angry bear.