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Proceed With Caution: Opportunities for Cash and Defensive Income Amid Uncertainty

We believe short-dated bonds can offer attractive yields, flexibility, and a means to proceed cautiously as central banks continue to raise interest rates.

U.S. Federal Reserve Chairman Jerome Powell’s recent Jackson Hole speech was a succinct and powerful pronouncement to vanquishing inflation that lacked support for near-term economic growth.

His message was a warning of potential hazards ahead as the Fed continues to fight any remaining inflation threats, either forecasted or unexpected.

Today’s markets are undoubtedly volatile, as investors face uncertain central bank policy (read about ECB policy here) and evolving market consensus outlooks for economic growth. We expect monetary policy to remain restrictive across major economies, despite slowing growth and rising recession risks, as global central banks struggle to gain control of persistent inflation. With the path to smooth returns across many asset classes overgrown with obstacles, we suggest investors consider the following potential benefits of investing in shorter maturity bonds:

  • Front-end yields increased to attractive levels: U.S. front-end yields have climbed over the past nine months and are near 15-year highs, which could make them potentially attractive investment solutions for investors compared to the recent past. With less interest rate and credit sensitivity, short-maturity bonds can potentially outperform longer-dated bonds when rates are rising and more credit-sensitive bonds when economic growth is waning. Moreover, given the shorter-maturity nature at the front end of the curve, combined with higher starting yields, short-term bonds and strategies have the potential to more quickly reverse losses caused by market volatility.
  • Positioning defensively provides flexibility to be opportunistic: We see a strong case for multi-sector portfolios to increase exposure to cash and shorter-maturity bonds to potentially increase liquidity and stability. Positioning portfolios defensively offers investors the flexibility to tactically maneuver when opportunities across various asset classes present themselves. Higher front-end rates and a flatter yield curve mean an investor doesn’t need to take substantial interest rate risk or sacrifice liquidity to receive attractive compensation for capital over the next year.
  • Short-duration portfolios may offer resiliency during heightened uncertainty: Investors should remain cautious while central banks continue to tighten. Shifting a portion of an investor’s asset allocation to a diversified fixed income portfolio with less than two years of duration can potentially provide liquidity and a relatively low risk solution amid increased market volatility if longer-dated yields rise more than expected and risk assets reprice into 2023.

Summary

While we believe it’s prudent to be cautious today, investors have opportunities to be well-compensated for their patience until the road is clear and conditions turn more favorable. The U.S. economy is at, or near, stall speed and the probability of recession appears higher over the next 12-18 months. One can actively manage around this economic uncertainty by reducing risk allocations, raising cash levels, and proactively managing liquidity in a way that is both defensive, but also optimized – an approach with the potential to realize liquidity premiums to benefit returns.

This chart shows the yield to maturity of the ICE B of A one-year U.S. Treasury Index at 31 August 2022 at 3.54%, up from just 43 basis points on 31 December 2022. Similarly, the chart shows the yield to maturity of the Bloomberg one-to-three year government credit index rose to 3.67% at 31 August 2022, from just 84 basis points on 31 December 2022. Finally, the chart shows the yield to maturity of the Bloomberg U.S. Aggregate Index was 3.93% at 31 August 2022, compared with 1.70% on 31 December 2022. 

Jerome Schneider leads short-term portfolio management at PIMCO.

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Jerome M. Schneider

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Past performance is not a guarantee or a reliable indicator of future results.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice.

Bloomberg U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis.  The Bloomberg US Government/Credit 1-3 Year Total Return Index measures the performance of US Treasury securities that that have a maturity ranging from 1-3 years. The ICE BofA Merrill Lynch 1 Year Treasury Index is an unmanaged index that tracks the performance of the direct sovereign debt of the U.S. Government having a maturity of less than one years. It is not possible to invest directly in an unmanaged index.

Yield to Maturity (YTM) is the estimated total return of a bond if held to maturity. YTM accounts for the present value of a bond’s future coupon payments. Duration is the measure of a bond's price sensitivity to interest rates and is expressed in years.

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