Q&A: Rising rates favor shorter maturities

03-07-2018

Q: What’s behind the recent surge in the 1-year area of the Treasury yield curve? It’s a combination of several factors. Of course, interest rates have been increasing in expectation of further moves by the Federal Reserve, with Chairman Jerome Powell's testimony before Congress last week reinforcing the likelihood of multiple hikes again this year. But the reduction of the Fed’s balance sheet—in essence a reversal of quantitative easing—also represents a form of monetary tightening. With more Treasuries out in the marketplace given the same level of demand, the clearing price has to go up. On top of that, the new tax bill has juiced the economy and will require the Treasury to issue even more securities to finance the subsequent increase in the fiscal deficit. Add to all of this the potential for inflation, and the Fed might get more aggressive than the expected path.

Q: What are some ways investors could navigate the rising-rate environment? In the fixed-income sphere, the key is to counter that by decreasing duration. That’s another word for interest-rate exposure, and a lower profile—i.e., reduced exposure to longer-term instruments and increased exposure to shorter-term instruments—can mitigate the risk of rising rates eating away at value. Another way of thinking of this: if rates are rising, a shorter-duration strategy can reset its assets at a faster pace than a longer-duration strategy, reducing potential capital depreciation. Ultrashort funds, for example, must maintain an effective duration of a year or less.

Q: What advantages does an ultrashort strategy offer? They are built for investors who want to reduce their interest-rate exposure while gaining better yields than similar maturity government securities—i.e., they are willing to take some credit risk, but not much. These funds tend to hold mostly investment-grade credits, federal agency securities and Treasuries. As credit spreads have tightened significantly over the past several years, investors may want to adopt a somewhat more defensive credit posture. Ultrashorts are often appropriate for investors who want to lower their credit exposure without eliminating it.

Randall Bauer
Randall Bauer, CFA
Senior Portfolio Manager, Head of Low Duration Strategies, Head of Structured Products Group

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