Fearing the Next Recession? Investing at the Front End of the Bond Market

Fearing the Next Recession? Investing at the Front End of the Bond Market

Now in its 10th year, the U.S. economic expansion could become the longest on record: Our forecast calls for the current “late-cycle” phase of the expansion to last 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.

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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.’”

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Jerome Schneider is PIMCO’s head of short-term portfolio management and is a regular contributor to the PIMCO Blog. Tina Adatia is a fixed income strategist at PIMCO, focusing on multi-sector and short-term strategies.

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Disclosures

*Short-term strategies based on Bloomberg Barclays Short Term Government/Corporate Index; equities based on S&P 500. It is not possible to invest directly in an unmanaged index.

All investments contain risk 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 the current low interest rate environment increases this risk. Current 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. 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 long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.