Now in its 10th year, the U.S. economic expansion could become the longest
Our forecast calls for the current “late-cycle” phase of the expansion
at least another year, barring any policy mistakes. However, we do think
growth is likely to slow somewhat in the year ahead as the effects of tax
reform fade, tighter financial conditions start to affect the real economy,
and risks like trade conflicts weigh on investors’ outlook.
After such a prolonged period of economic growth and easy monetary
conditions – which have helped buoy prices for equities and other risk
assets – investors may be wondering if it’s time to take some chips off the
table. The turn in an economic cycle is difficult to predict, but with the
prospect of volatility increasing as rates continue to rise and financial
conditions tighten, it may be prudent to consider reducing risk and
focusing on more stable sources of potential income with lower exposure to
changes in interest rates.
We think short-term bond strategies can strike such a balance for
investors: They can offer a defensive strategy that may both reduce risk
and tap into diversified sources of higher yields at the front end of the
bond market during this late-cycle phase.
Here are five ways we think short-term investments may be able to help
investors maintain a more defensive posture in the months ahead:
1. Lower duration profile. Short-term bonds have lower duration, typically one year or less, and can
therefore help reduce a portfolio’s exposure to interest rate changes as
the Federal Reserve continues to gradually raise rates. Moreover, with the
relatively flat yield curve today, it is possible to earn similar yields
with a lower duration profile when moving to shorter-term investments from
intermediate- and longer-term bonds.
2. Lower volatility versus other strategies. Short-term bonds tend to have low volatility, especially relative to
traditional higher-risk assets, such as equities: Historically, volatility
in short-term bonds over a 10-year period has been less than 1% (compared
with about 15% for equities).* Reducing volatility can be helpful in an
aging expansion as uncertainty over future economic growth and the path of
interest rates rises.
3. Flexibility. Short-term bonds are generally more liquid
than longer-term investments and can offer investors the flexibility to
reinvest relatively quickly in other assets, including equities, if
valuations become more attractive.
4. Attractive current and potential yield from increasing rates.
Yields have risen significantly on short-term bonds
over the past year, overtaking equity dividend yields and closing the
distance on 10-year Treasuries as the yield curve has flattened. This means
that investors in short-term bonds can potentially reduce risk and be
compensated for it with higher yields and income.
5. Preventive active liquidity management (PALM). Managing liquidity should become a growing consideration for investors,
as monetary stimulus is expected to continue to ebb over the next few
years. While we don’t foresee a crisis in liquidity, subtle changes are
likely. Rather than rely solely on traditional liquidity tools that have
limited flexibility, investors may want to consider taking preventive
measures with actively managed short-dated bond strategies, which have
greater flexibility to navigate changing market conditions.
We think a recession in the U.S. is likely in the longer term ‒ over the
next three to five years ‒ but in the meantime, the expansion may have some
room to run. Short-term bonds can help investors take some risk off the
table while remaining in the game of seeking quality risk-adjusted returns
and higher income as benchmark rates move higher.
U.S. readers: Read more about
fixed income investing ideas
ahead of the next recession.
For more on the value we see in the short-term bond market, please see
Value in Short Bonds: ‘We’re Not in Kansas Anymore.’”
Jerome Schneider is PIMCO’s head of short-term portfolio management and is a regular contributor to the
Tina Adatia is a fixed income strategist at PIMCO, focusing on multi-sector and short-term strategies.