As we approach the holiday season, most investors are beginning to think about escaping to somewhere far and exotic or spending time with family and friends. Unfortunately, while our social calendars are working overtime, markets don’t always take a break during the festive season. So investors concerned about rising rates or sudden equity market drops may want to consider lowering risk in their portfolios as part of their preparation for the holiday season.
In an aging economic expansion, when changing liquidity conditions and costs can lead to more market volatility, a short-term bond strategy can provide balance for investors: a defensive approach that reduces interest rate risk while tapping into diversified sources of yield at the front end of the bond market.
Preparing for rising rates: Rising interest rates are a fixture of late-cycle markets. Over the next 12 months, interest rates are likely to grind higher, particularly in the U.S., where economic growth remains above trend. PIMCO forecasts three additional policy rate hikes from the Federal Reserve by the end of 2019, and we expect the Fed to continue running down its balance sheet at least through the fourth quarter of next year. Short-term bond strategies have low duration, typically one year or less, and therefore can help reduce a portfolio’s sensitivity to interest rate changes as the Fed gradually raises rates. Moreover, with today’s relatively flat yield curve, investors in short-term bonds can earn yields similar to those on intermediate- and long-term bonds but with less interest rate exposure. Additionally, short-term portfolios can be positioned to benefit from rising rates and higher yields as benchmark rates continue to increase.
Minding the dips/lowering volatility: Many investors have become conditioned over the past decade of economic expansion and the equity bull market to “buy the dips,” but as financial conditions tighten, they may now want to “mind the dips.” The overwhelming assumption is that higher rates helped cause equity markets to balk in October, and judging by the Federal Open Market Committee’s largely unchanged November statement, higher equity volatility is not a major concern for the Fed so far. Because short-term bonds tend to have low volatility, especially relative to traditional higher-risk assets, allocating a portion of a portfolio away from risk assets and into short-term could help reduce overall portfolio volatility. (Historically, volatility in short-term bonds over a 10-year period has been less than 1% compared to about 15% for equities.*)
Managing liquidity: As rates rise and volatility increases, investors may be tempted to reduce risk by moving to bank certificates of deposit (CDs). CDs at an insured bank in the U.S. offer a fixed interest rate, typically higher than that on a standard savings account, and as bank deposits, they are insured up to $250,000 (per account, per bank, per ownership category) by the Federal Deposit Insurance Corp. (FDIC) in the event that the bank fails. However, CDs are time deposits, requiring specified investment periods, or “lock-ins,” of anywhere from a month to several years, and withdrawing early usually results in penalties or forfeiting interest earned. We think this can create drawbacks for investors. Depending on the strategy, investors in short-term bonds may have more ready access to their assets. In today’s market, this can mean the flexibility to reinvest as interest rates rise and when prices for other assets, including equities, become attractive ‒ the very reason that many investors today may be holding high cash and short-term allocations. Furthermore, national average CD rates as of mid-November ranged from 0.56% for one year to 1.20% for five years, according to the FDIC, which are still lower than the fed funds rate and prevailing short-term benchmarks. Actively managed short-term bond strategies can invest in a broader universe of securities and thus aim for higher returns than traditional cash vehicles.
While actively managed short-term bond strategies come with some distinct benefits, including the pickup in return potential, investors need to carefully weigh the pros and cons. Unlike bank CDs, short-term bond strategies are not insured by the FDIC, are not a deposit or obligation of a bank, and are not guaranteed. They are subject to investment risks, including possible loss of principal.
Preparation is key
For investors looking to prepare their portfolios for the likelihood of more volatility in the months ahead as the Fed continues to raise rates gradually, a short-term bond strategy can offer a simple way to lower risk while still seeking to generate income and maintain liquidity.
For more on short-term bonds, please see “Fearing the Next Recession? Investing at the Front End of the Bond Market.”
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 rel="noopener noreferrer" short-term strategies. Kenneth Chambers is a fixed income strategist focusing on income and short-term strategies.