Uncovering the yield opportunity in ultrashorts
Portfolio manager Randall Bauer offers insight on how and why ultrashort bond funds can support income-seeking investors in a low-rate world—or any time.
Q: Could you explain the Federated Ultrashort Bond Fund strategy?
The fund offers investors access to a strategy with a multipronged approach, focusing on credit risk, interest-rate risk and liquidity. It is built for income-oriented investors who want to limit their interest-rate exposure—the fund maintains an effective duration of a year or less—while seeking better yields than similar maturity government securities, i.e., they are willing to take some credit risk, but not much. The fund is invested predominantly in investment-grade securities. It can provide an attractive complement to cash and money market investments by offering a potential yield advantage in exchange for limited share price fluctuations.
Q: What is the appeal of ultrashort bonds in a declining or overall low-rate environment?
As interest rates fall, a bond fund will tend to hold a higher income stream longer than a money market fund. This is because the higher coupon securities held in a bond fund purchased prior to any decline in rates will take longer to mature than money market securities, so the higher yield will tend to be maintained for a longer period of time. When securities mature in any mutual fund portfolio, the proceeds need to be redeployed in new securities, which will have lower yields in the event interest rates are falling (or higher yields in the event interest rates are rising).
While money market funds are able to purchase higher-yielding securities sooner when interest rates are rising, there generally is a yield advantage to an ultrashort fund relative to a money fund in any rate environment given the ultrashort fund’s broader opportunity set: it can include short-duration, primarily investment-grade, corporate, mortgage-backed and asset-backed securities. Since the majority of an ultrashort’s total return is generated by the yield on the securities in the portfolio, this generally means that an ultrashort fund may generate a higher total return as well. Unlike a money market fund, the principal value of an ultrashort fund will fluctuate. This can contribute to total return but also result in principal loss when rates are rising, although this risk is less than with longer-term, higher-yielding bonds. Yield curves are normally positively sloped, meaning one’s income opportunities generally increase by moving out the curve.
Also favoring shorter-term bonds is the fact that unexpected events can affect markets at any time, so we believe an ultrashort fund’s conservative profile has a place in just about every portfolio that is able to withstand some volatility.
Q: How do asset-backed securities fit into an ultrashort portfolio?
Asset-backed securities (ABS) are well suited to an ultrashort portfolio because their maturities tend to be shorter in nature. Much of the ABS market is based on consumer debt—auto loans, credit cards, equipment leases, time shares, insurance premium receivables and other shorter-term assets with typical maturities of four to five years. By contrast, corporate loan maturities can extend up to 30 years. Also, ABS can be structured and their cash flows parsed into shorter-term bundles of securities, or tranches, making them eligible for investment in short-duration products like ultrashorts.
Although they lack the guarantee of a U.S. government security, a feature of ABS is that they are secured by collateral and credit-enhanced with internal structural features or external protection that supports them.
But most important, we’re very selective about every security we purchase. Not only are securities intensely reviewed before investment, they are continuously monitored as long as they are in the portfolio. For investors with the experience, data and extensive resources to perform the necessary analysis across collateral, structure and servicers—as is the case here at Federated—ABS offer the potential to generate higher yields compared to government bonds without assuming substantial additional risk.
Q: What is the outlook and positioning for the strategy over the next 3 to 6 months?
The Federal Reserve has indicated it will likely pause its rate cuts unless there is clear evidence of a downward economic shift. Nonetheless, we expect to remain in a longer-term low-rate environment. Also contributing to lower yields are the negative interest rates in many regions of the world. This has increased the demand and lowered yields for U.S. bonds. At this time, we are positioning our portfolios a little bit longer and remain positive on credit spread products, specifically investment-grade corporate and ABS. In buying these credit-sensitive bonds, we aim to generate some modest amount of capital appreciation in addition to the coupon yield earned on the portfolio.