This Is a Good Time to Buy Short-Term Bonds

But this could be a good entry point for short-term bonds: They may not fall much more, and yields are now high enough to withstand some price pressure. “We are actually comfortable owning the front end of the yield curve here,” says Bob Miller, head of Americas fundamental fixed income at BlackRock.

Granted, this a wacky time for bonds. The yield curve is now inverted: Most short-term bonds yield more than long-term notes, such as the 30-year Treasury at 3.47%. The upshot is that investors aren’t being compensated for holding long-term bonds. Quite the contrary: Yields are lower, and duration risk—or sensitivity to rates—is higher at the long end.

Short-term funds have racked up losses this year. The iShares 1-3 Year Treasury Bond exchange-traded fund (ticker: SHY), a proxy for Treasuries, is down 3.85%, after interest.

Yet some analysts think that short-term yields may now be close to pricing in the remainder of the Fed’s rate increases. With yields at nearly 4%, there’s far more of an income cushion against price declines. Investors may also scoop up a bit more income than with cash proxies like money-market funds, now yielding about 2%.

“When you have a 3.75% yield, that’s much more manageable,” says Cary Fitzgerald, head of short-duration fixed income at J.P. Morgan Asset Management.

The risk still out there is the “terminal” federal-funds rate—the point at which the Fed pauses its increases.

Currently in a range from 2.25% to 2.5%, the fed-funds rate is expected to rise sharply from here. The futures market sees a 75% chance of a three-quarter point hike when Fed officials meet this coming week. Another rate hike is expected in November, putting the rate around 4% in December.

The futures market is expecting the fed-funds rate to peak at 4.4% in the first quarter, following a consumer price inflation reading that came in much hotter than expected in August.

Terminal rates of 4.75% or even 5% aren’t impossible, however, under a range of scenarios: Inflation stays hot, the war in Ukraine continues to disrupt energy prices, or supply chains don’t get back to normal, exerting more upward pressure on prices. “Really, what it comes down to is what the average fed-funds rate will be for the next two years,” says Fitzgerald.

The bond math does seem favorable for short-term notes. At a duration of two years, for instance, the two-year Treasury note would lose 40 basis points, or 0.4% in price, for another 20 basis point rate increase by the Fed. (A basis point is 1/100th of a percentage point.) Even if the Fed were to raise rates by another 175 basis points, the bonds could generate positive returns over their lifetime.

Inflation data aren’t predictable, of course, but some bond managers say the market has largely priced in a terminal fed-funds rate. BlackRock’s Miller thinks the two-year Treasury’s yield embeds the rate peaking around 4.3% in the first quarter of 2023. “The two-year note looks like a reasonable asset,” he says. “Is it screamingly cheap? No. But it’s no longer ridiculously rich like it was a year ago.”

Tom Tzitzouris, head of fixed-income research at Strategas, says short-term yields are also now in the terminal ballpark. If that’s the case, he adds, “you’re basically going to clip your coupons in two-year Treasuries because the market has already priced in the tightening.”

Opportunities in shorter-term bonds aren’t confined to Treasuries. John Bellows, a portfolio manager at Western Asset Management, likes investment-grade corporate debt, which features both a yield component and some income from the credit risk embedded in the bonds.

“We have a widening in credit spreads at the very front of the curve,” he says. The spread on one- to three-year investment-grade corporates was recently about 75 basis points over corresponding Treasuries, putting yields in the neighborhood of 4.5%. “Over a three-year period, there is a lot of potential total return,” he says.

Mark Freeman, chief investment officer at Socorro Asset Management, also likes short-term corporate debt. “With risk-free rates in the 3.75% range and high-quality corporates yielding in the 4.25% to 4.75% range, it’s not a bad place to be in a volatile investment environment,” he says.

Various mutual funds and ETFs offer exposure to the shorter end of the yield curve. For pure Treasuries, the $26 billion iShares 1-3 Year Treasury Bond ETF offers broad diversification at a low fee. It has an SEC yield of 3.31% and an expense ratio of 0.15%.

For corporate bond exposure, consider the $43 billion

Vanguard Short-Term Corporate Bond
ETF (VCSH), an index fund covering the broad market. It sports an SEC yield of 4.22% and an expense ratio of 0.04%. The fund is down 5.85% this year, after interest payments, trailing 78% of peers. But its razor-thin expense ratio has helped push it ahead of nearly 90% of rivals over the past 10 years, according to Morningstar. Its holdings as of July 31 included debt issued by blue-chip names such as

JPMorgan Chase

(JPM),

Bank of America

(BAC), and

Goldman Sachs Group

(GS).

Among the short-term investment-grade bonds that Freeman holds in client portfolios is one issued by

Home Depot

(HD) that matures in 2025 and has a yield to maturity of 4.25%. Freeman cites the retailer’s “dominant market share, loyal customer base, and forward-thinking executive management team.”

Also in his portfolio is a

Phillips 66

(PSX) bond with a yield to maturity of 4.5%, and a bond issued by

Target

(TGT) maturing in 2025 with a yield to maturity of 4.2%.

Assuming the Fed doesn’t get much more hawkish, this rate cycle should peter out in six months or less. As these yields show, the short end of the curve doesn’t always equate to the short end of the stick.

Write to Lawrence C. Strauss at [email protected]