These should be the halcyon days for fixed income investors. Current yields are at highs not seen in years, while the Federal Reserve is starting to cut rates and proceed with monetary easing. All of this should produce some hefty total returns for bond portfolios. And yet, yields have continued to rise and volatility has increased.
Uncertainty amid economic conditions, inflation, and future Fed policy remains.
For bond investors, this is a real difficulty and issue. But it is solvable. The answer may be focusing on the dual mandates of going short and focusing on credit. This is where investors can lock in good yields while still limiting the effects of volatility.
New Issues Form
After the bond rout of 2022/2023, this year was supposed to be the year of bonds. The dip in prices coupled with rising rates gave a wide variety of fixed income types some of the largest yields since the 1990s. Investors could lock in 4.5%+ in the safety of Treasury bonds or even cash.
Then the dip in inflation from 1980s-style highs allowed the Fed to start cutting benchmark interest rates. This should provide a big boost to bond prices and help drive a hefty total return for bonds and fixed income.
And yet, bonds have fallen a bit flat over the last few months.
Part of that has continued to be uncertainty about inflation. Yes, inflation has fallen from its highs. But it has stayed steadily above the central bank’s 2% target. To make matters worse, inflation has begun to rise. The Consumer Price Index (CPI) rose 0.2% in October, boosting inflation higher to 2.6% annually. This puts the Fed in a tight spot. Can they further cut rates to accommodate slowing economic growth without risking spiking inflation further? Certainly, the path to lower interest rates is now fraught with many starts and stops, which analysts and bond investors were not prepared for.
Then there is future uncertainty to be concerned with.
Incoming President-elect Trump has promised to extend the 2017 Tax Cuts and add new tax cuts to the docket. In the short run, these tax cuts could be beneficial. However, many tax policy experts and economists have now started to question just how much deficit they will create. Some estimates have been as high as $15 trillion. This has made the bond market nervous. To compensate for that, investors are now demanding higher yields from safe U.S. Treasury bonds. With that, prices have fallen.
Year-to-date, the bond benchmark—the Bloomberg US Aggregate Bond Index—total return is 3.11%. On price, the Agg is actually showing a loss. It’s the yield and coupon of the index that is providing actual positive returns for investors.
The Short Credit Answer
The issue is these various trends don’t look to be abating anytime soon. Inflation seems to be here to stay and potentially could rise under new presidential policies. At the same time, a lack of government revenue could pinch Treasury bonds further. The Federal Reserve is stuck about its interest rate policies and its ability to cut rates further.
For fixed income investors, these risks expose them to a wide variety of risks, volatility, and potential losses in their portfolios. But there could be answers to the woes.
According to investment manager State Street, going short and focusing on credit could lead to big wins, optimized income, and lower volatility.
Short-term makes sense. Bonds with near-term maturities—between one year and 3.5 years—aren’t nearly as volatile as those with longer timelines. This has to do with duration and how bonds react to rate increases and rising yields. Because of their shorter timelines, short-term bonds have lower durations. They are able to ‘roll over’ faster than a 30-year bond. The result is they are less volatile to rate changes and sell-offs.
This chart from State Street shows the lower volatility of short-term bonds in a wide range of categories.
Source: State Street
Part two focuses on credit. While U.S. Treasuries are considered the gold standard in the world of fixed income, they might not be the best choice for investors, particularly if the Fed is forced to pause its rate cuts and yields are forced to rise amid new budget/revenue/tax challenges. All the bonds issued outside the federal government—such as corporate bonds, junk debt, and commercial real estate loans—could be a better bet.
State Street notes that overall credit quality has continued to improve. After a string of negative quarters, earnings for U.S. equities are poised to record their fourth consecutive quarter of growth and quarterly earnings growth estimates are all positive for 2025. Moreover, bond ratings have started to show significant increases. Looking at downgrade-to-upgrade ratios, after several quarters where downgrades were the norm, Q2 of the year moved this ratio back to 1 and now it is showing more upgrades than downgrades. 1
The win is investors are getting a better yield in corporate credit than U.S. Treasuries for the lower default rates. High yield bonds are still paying close to 8%, floating rate bonds are paying closer to 9% while investment-grade corporates are paying 5.5%+. Spreads—or the amount of extra yield you receive—between credit and Treasury bonds remain rich as well.
The Short-Credit Combo
Together these bonds can be a powerful tool to optimize your income and reduce portfolio volatility. Short-term bonds can provide some needed balance while still providing high yields. Credit can provide the needed extra boost to provide fixed income portfolios with higher yields. Together, the combination can work better than a portfolio of intermediate bonds or the Agg index.
The question is how to do it. State Street recommends a mixture of corporate bonds, with maturities of one to 10 years, and senior loans to make up the mix. Senior loans and other floating rate debt have short-term maturities and coupons that change with measures of interest rates. The corporate side of the equation allows investors to pick up stability and strong yields. These two areas of the bond market could be combined with short-term Treasuries to provide added conservatism for investors looking to reduce their volatility/risk further. However, yields may be lower.
Short-Term Bond ETFs
These ETFs are selected based on their ability to tap into short-term duration bonds at a low cost. They are sorted by their one-year total return, which ranges from 1.6% to 4.8%. Their expense ratio ranges from 0.03% to 0.56%, while they yield between 1.9% and 5.1%. They have AUM between $730M and $58B.
| Ticker | Name | AUM | 1-year Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| DFSD | Dimensional Short-Duration Fixed Income ETF | $1.55B | 4.8% | 3.9% | 0.18% | ETF | Yes |
| FSIG | First Trust Limited Duration Investment Grade Corporate ETF | $731M | 4.8% | 4.6% | 0.56% | ETF | Yes |
| LDUR | PIMCO Enhanced Low Duration Active ETF | $989M | 4.5% | 4.7% | 0.51% | ETF | Yes |
| SPSB | SPDR Portfolio Short Term Corporate Bond ETF | $7.3B | 4.6% | 5.1% | 0.04% | ETF | No |
| SCHO | Schwab Short-Term U.S. Treasury ETF | $12.4B | 3.5% | 3.9% | 0.03% | ETF | No |
| SHY | iShares 1-3 Year Treasury Bond ETF | $26B | 3.4% | 3.8% | 0.15% | ETF | No |
| BSV | Vanguard Short-Term Bond ETF | $58B | 3.3% | 3% | 0.04% | ETF | No |
| SUB | iShares Short-Term National Muni Bond ETF | $8.8B | 1.6% | 1.9% | 0.07% | ETF | No |
Short-Term Junk Bond ETFs
These funds were selected based on their allocations to short-term junk bonds. They are sorted by their YTD total returns, which range from 0.4% to 3.3%. They have expense ratios between 0.30% and 0.98% and have assets under management between $27M to $5.54B. They are currently yielding between 3.9% and 7.8%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| FHYS | Federated Hermes Short Duration High Yield ETF | $27M | 3.3% | 6.3% | 0.51% | ETF | No |
| SHYG | iShares 0-5 Year High Yield Corporate Bond ETF | $5.54B | 2.9% | 7% | 0.30% | ETF | No |
| HYS | PIMCO 0-5 Year High Yield Corporate Bond Index ETF | $1.22B | 2.6% | 7.8% | 0.56% | ETF | No |
| IBHG | iShares iBonds 2027 Term High Yield and Income ETF | $96M | 2.4% | 6.8% | 0.35% | ETF | No |
| SJNK | SPDR Bloomberg Short Term High Yield Bond ETF | $4.55B | 2.3% | 7.6% | 0.40% | ETF | No |
| SJB | ProShares Short High Yield | $114M | 0.4% | 3.9% | 0.98% | ETF | No |
Overall, there are plenty of risks for investors in the fixed income space. Rising inflation and the inability of the Fed to cut rates further, coupled with rising budget deficits, are all recipes for a rocky environment. For investors, the answer may lie in the short credit combo. Here, investors can still pick up yields while reducing their volatility and risks.
Bottom Line
This was supposed to be the year of bonds, with high yields and rising prices creating a great total return. However, new risks have put bonds and fixed income portfolios in a tight spot. However, all is not lost. Investors can focus on short-term bonds and credit opportunities for better income and lower volatility.
1 State Street (September 2024). Optimize Income With Short-term Core and Credit
