When interest rates fall through the floor, the ability to generate income becomes more difficult, and more valuable. As of May 22, for example, the yield on 10-year U.S. treasuries was around 0.67%. Not a lot.
The challenge is a familiar one: everyone wants more income, but generating it from bonds usually means going further out on the yield curve, or investing in riskier assets. In times of high volatility and economic uncertainty this may not be an attractive option for many investors.
Going short, however, doesn’t mean having to forgo all income. A corollary to living in a time of extremely low interest rates is that every additional basis point counts. A hundred basis points – one percent – matters a lot. There are a wide variety of debt instruments available to investors in addition to treasuries, many with higher yields. These include corporate bonds, mortgage-backed securities, asset-backed securities, and convertible corporate bonds, among others. As with other types of debt, maturities and credit quality are variable but it is possible to have a portfolio of these instruments that is short duration, investment grade, and with a more attractive yield than that currently offered by 10-year treasuries.
Duration and credit quality are the key. Duration is a tool for measuring how a security will react to a change in interest rates. The longer duration the more sensitive (volatile) it will be to interest rate changes. Duration is different than simple maturity – the date on which principal is required to be repaid – in that it incorporates other characteristics including yield, coupon payments, principal payments and call dates. As the value of an instrument changes over time, so will its duration. Shorter duration usually translates into lower volatility.
Credit quality is the second major variable in any fixed income portfolio. Higher rated securities are generally safer; the trade-off is a lower yield. But of course risk is also a function of time. In an ideal world, all bonds would pay off at maturity (or before). In the real world, going out longer on the curve adds uncertainty. Many investors would prefer not to have to worry about that additional risk. Keeping duration at or around one year can help address that concern.
The other side of the income equation is the practical one: what it means for purchasing power. What can you buy with the dollars generated by your portfolio? How is that impacted by inflation? Deflation? Interest rates are down, but many prices have been moving down as well as seen in the 0.4% decline in the April Consumer Price Index (CPI), the biggest drop since 1957 (though interestingly, the costs for food at home rose by 2.6% in the same period as locked-down consumers headed to the grocery stores or took advantage of delivery options to stock up). That means that while coupon payments on short-term funds may be low, they have generally moved with overall price levels, providing some protection for purchasing power for income-oriented investors.
Finally, there’s preservation of capital. Investors who are concerned about market volatility but want to continue to generate potential income may find going short to be an attractive solution. One vehicle with such an objective is an actively-managed ETF like the IQ Ultra Short Duration ETF (ULTR). It invests in a diversified mix of short-term, investment grade fixed income instruments. Its recent SEC 30 day current* yield was 1.33% as of May 31, 2020.
Going short doesn’t have to mean going without yield.
Related: Will Consolidation Follow the Current Economic Weakness?