The Advantages of Short-Duration Strategies in a Rising Rate Environment

Many investors are concerned about the headwinds fixed income investments are faced with today given the current economic environment and the pace at which the Federal Reserve has increased interest rates. However, SBH believes we are at a point where this environment presents opportunities for investors, many of which are currently sitting on the sidelines.

Hear our perspective on this opportunity and why we believe investors can access higher yields through short-duration strategies in our podcast featuring Michael Diehl, CFA, Senior Portfolio Manager, and Mark Rewey, Director of Marketing & Business Development.

Learn more about our Fixed Income Strategies.

 

[Mark Rewey] Good day I’m Mark Rewey, head of sales at Segall Bryant & Hamill. Joining me today is senior portfolio manager and our fixed income team Mike Diehl. And this is the advantages of short duration strategies in a rising rate environment. Today investors are concerned about the headwinds fixed income investments face in our current economic environment particularly given the pace of the Fed’s interest rate hiked so far in 2022. However, we feel we are at a point where this environment presents opportunities for investors many of which are currently sitting on the sidelines. Mike, thank you for joining us today. Could you first talk about the current state of our investors in this market including their cash holdings?

[Michael Diehl] Sure. Happy to be here, Mark. Yeah, a lot of exciting things are happening in fixed income particularly on the short end of the yield curve. But yeah, getting back to your question, current state of investors I think it’s important to take a quick step back. Just look at what happened over the last two years. Not only in our daily lives, but these markets have experienced just so many different twist and turns. There was COVID, result of COVID, Fed came in and backstop the entire market. The US government unleashed records amount of cash stimulus to corporations, individual, almost anybody to try to prop up the economy that at the time, people were panicked. They didn’t know what was going on personal lives, investment lives, business life, et cetera. And as a result of this, interest rates also fell to extremely low levels. You know, taking a step back year later, we had huge positive investment returns. The economy started to recover and investors had continued growth in their cash balances. The one problem was they didn’t really have an attractive option to invest their excess cash. Today the world happily is recovering from COVID but the markets are seeing are seen volatility spike for different reasons. Inflation’s at the highest it’s been since the early ’80s. Unfortunately, we have a war going on overseas. The Fed is starting to increase interest rates and removing the accommodation they had in place for the last 10 years. And we’re seeing a rise in interest rates particularly on the short end of the yield curve. The result of this is we’ve seen pretty negative market returns for 2022, and we’ve seen a huge increase, continued increase in this record amount of cash on the sidelines, almost $4 trillion. The good news is with this increase in interest rates, investors now have an attractive option for their excess cash. And that is short duration fixed income, which is what we’re here to talk about today.

[Rewey] Mike, that’s a great backdrop. So the table is set. With that said, how does our current rate environment provide an opportunity for investors to optimize their cash without taking a lot of interest rate or market risk?

[Diehl] Well, there’s been a lot of volatility in the market but the one thing it has given investors is higher short term rates and significantly higher short term rates. We’re talking over 200 basis points higher than they were two years ago. And these higher rates they’ve given investors cushion. Now investors can buy short duration fixed income securities at higher yields in the duration of those securities and this investment cushion, like we like to call it just provide some flexibility. If interest rates do go up if there’s a corporate widening, spreads wide on short duration securities this investment cushion protects investors. And so it just at these higher rates, yes it’s been painful to get here. It’s caused volatility in the marketplace but it’s also given investors a great place to utilize their excess cash that they didn’t have before. And so that’s why we are happy with these higher rates. I think it’s important that we talk about it because it’s really been a huge move and it’s something investors can take advantage of that they weren’t able to before.

[Rewey] Mike, that’s really interesting. So use the term cushion. Explain to me elaborate on that if you will, what that means.

[Diehl] So cushion is every fixed income investment has a yield and a duration. And what we mean by cushion is when the yield is greater than the duration, duration is a bond price sensitivity to a change in interest rates. So a current short duration yield take a three year treasury has a yield of well over 280, a duration of 190. So if interest rates increase 1%, that investor’s earning 280 on that, even if the bond price goes down 1.9%, they’re still having a positive total return. So when we mean by investment cushion, that yield is higher than a duration and it offers some protection that the investor didn’t have when yields were significantly lower and less than the duration of the underlying security

[Rewey] Mike, in your view, what are the most attractive options for investors to access these now more attractive yields?

[Diehl] Well, Mark historically money market funds have been the parking spot for investors for their excess cash. And this is really going back to 1980 but there’s some issues with money market funds now in the great financial crisis, they broke the dollar and the rules have changed from these funds and now they can potentially gate investors. And with that downturn in money market funds we’ve seen huge growth in some of these bond, ETFs, and mutual funds. In fact, some of these are the largest bond funds in the world. They’re short duration securities but they’ve shown in times of stress, particularly the latest example would be COVID in March, 2020. These funds are so big, so large there’s fast money investors in these funds that when the market gets really, you know, volatile these funds can experience high, high withdrawal amounts. And so if you’re an investor in these funds even if you don’t need to sell just the magnitude of the other investors that are taking liquidity these funds can have pretty outsized negative returns. In fact, one of the largest funds out there was down 9% in March, 2020 alone just due to these liquidity type event. Other things with short duration, it’s a very broad category. And some of these bond ETFs and mutual funds there’s not a lot of transparency. So some funds for example, have put, you know at the time short average maturity securities but they actually have long, final or short average life but long final maturity securities. And so when interest rates were low these were short average life bonds interest rates have increased pretty significantly. And now this has turned into a longer duration investment. So it’s just really important. Short duration investments are very attractive but it’s important for the investor to understand what they’re really owning. If it’s in a bond ETF or mutual fund or to be cognizant of any potential gating if it’s in a prime money market fund.

[Rewey] So that’s important. So size can work against you. Transparency can be a challenge and of course liquidity can be a challenge as well. All important things for investors to be aware of. Another thing you should be aware of at Segall Bryant & Hamill, we do offer separate accounts and mutual funds is offerings in the short duration space. We have a ultra short and short term separate account. These are investment grade securities one to three year portfolios. We also offer a short term plus portfolio that allows us to go slightly below investment grade, owning double B securities for that little bit of extra yield. And again, these are in separate accounts where you can own the individual securities and have the ability to customize the portfolio based on the client’s needs and goals. We also have a mutual fund for a short duration plus as well. Given that many believe the Fed will continue to raise interest rates, does it make sense to wait to invest in short duration strategies?

[Diehl] That’s a great question, Mark. And we’ve heard that from different investors throughout the year. And the answer is I don’t think so. First inflation’s really high. It’s over 8% on the last CPI print. And so by holding cash in a checking account which is basically earning zero, the investor is actually diminishing their purchasing power given that inflation is so high in the marketplace. The second reason is the current Fed funds rate is 75 basis points. The current two year rate is over 260. That’s a big difference. And a lot of these potential interest rate hikes are already priced in. So by investing now, the investor’s able to take advantage of basically these higher rates right away versus waiting for the Fed to continually increase rates over time. And lastly, our portfolios there’s zero to three year portfolios. There’s always bonds coming due maturing. This provides a lot of flexibility in addition to the cushion we mentioned earlier and that if rates do go substantially higher, we’re constantly able to reinvest these maturities at higher rates to capture higher yields for these investors. So given what I mentioned, it’s a good question but we think right now is a very appropriate time to put money to work in short duration fixed income

[Rewey] And certainly a story we’re going to continue to watch unfold. Mike Diehl, senior portfolio manager at Segall Bryant & Hamill. As always, thank you for your insights.

[Diehl] Thanks Mark.

 

The opinions expressed in this podcast are solely the opinions of Segall Bryant & Hamill or an unaffiliated third party. You should not treat any opinion in this podcast as specific inducement to make a particular investment or follow a particular strategy, but only as an expression of opinions. The opinions expressed in this podcast are based upon information considered reliable, but completeness or accuracy is not warranted, and it should not be relied upon as such. Market conditions are subject to change at any time, and no forecast can be guaranteed. Any and all information perceived from this podcast does not constitute financial, legal, tax, or other professional advice and is not intended as a substitute for consultation with a qualified professional. The opinions and statements are subject to change without notice and Segall Bryant & Hamill is not obligated to update or correct any information in this podcast. For illustrative purposes only.

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