No Regrets: Avoiding an Ultrashort Hangover
A short-term soiree
It’s been tons of fun at the ultrashort bond rate party. Investors entertained tactical game plans, sampled at the high yield table and played a clever hand betting on ultrashort duration. Satisfied, they plan to leave this Gatsby-esque scene having outplayed the market’s attempts to keep them longer than intended. But the allure of an ultrashort cocktail spiked with high yield is too strong to ignore and instead of earning the satisfaction of time well-spent, investors who extend their ultrashort bet run the risk of waking to the undeniable odor of gin and regret.
The hottest place to be
With short term rates exceeding those of some longer-term bonds, and spreads incredibly tight, one of the hottest places to be for yield has been at the shortest end of the curve. Investors have looked to ultrashort funds as a good fit between money market options and longer-term rate strategies as a flattening yield curve leaves limited solutions for attractive yields.
But higher yield doesn’t come without higher risk, and ultrashort funds, while less susceptible to rate risk, can present credit risk when there is an attempt to boost yield. In their hopes to gulp income, investors may have lost sight of the fact that ultrashort funds still possess risks. They may have blanked on fixed income’s key role: to help with capital preservation through adding stability and diversification.
Know your limit
Too often, investors overestimate their ability to forecast the direction of interest rates.
In the chart below, take a look at six-month interest rate estimates by economists versus yield movements for the past five years. Not only were the consensus estimates wrong, but in most cases, they were very wrong. Investors who think they have the ultrashort party beat may just be reeling from their own optimism bias.
Once the lights come up on ultrashort returns against short-term bonds (see table below), the short-term category is the standout in all but one year—showing that, historically, ultrashort opportunities are often just, well, ultrashort. Is it worth the risk to an investor’s principal to linger?
Avoiding the hangover
Understanding that many investors use short-term or intermediate-term bond funds as a core fixed income allocation, perhaps the true “sweet spot” for stability lies in the three- to five-year duration range, just a bit farther out on the yield curve than ultrashort. Investors can take advantage of attractive short-term rates but with less interest rate risk than a traditional intermediate-term core bond fund.
But, don’t drink up just any 3- to 5-year bond fund. Seek a fund that is flexible in its approach to take advantage of opportunities across the asset class. A flexible approach can also ensure a portfolio is adequately diversified by sector, issuer, and credit cyclicality. Pairing flexibility with a time-tested structure, such as a laddered bond portfolio, can protect in a rising interest rate environment by spreading risk across maturities and reinvesting dollars when rates rise. Principal loss can be reduced while an income stream is established, serving the role of a fixed income allocation—without regrets.