Fixed-income focus: Beware ending up with the 'ultra-short' straw

Given the changing outlook on Federal Reserve rate moves, fixed-income decisions taken last year warrant a rethink

Jun 12, 2019 @ 11:05 am

By Gautam Khanna

So far this year, the Federal Reserve has gone from being in a firm rate-hiking cycle into a so-called "Powell pause" — where it put interest rates on hold due to slowing global growth and rising risks to the U.S. economy.

Following an extension of the "pause" at the May Federal Open Market Committee meeting, with a nod to inflation running below 2%, the question markets are pondering now is whether the Fed could cut rates before the end of the year.

This change in rhetoric from the U.S. central bank has called into question a popular asset allocation call of 2018, which saw more than $70 billion flow into the Morningstar ultrashort bond category as of Dec. 31.

(More: Investors are headed to extra innings)

Last year, the overarching market view was that the Fed would continue its rate-hiking cycle through 2019, based on underlying economic strength and relatively hawkish language from Fed chairman Jerome Powell. As a result, many investors chose to reduce duration in their portfolios by moving into ultrashort assets — a common approach in a rising interest rate environment.

In our view, the thesis behind this allocation is now in question. The Fed dot plot now shows zero hikes in 2019, according to Bloomberg as of May 1, while the futures market appears to be fully pricing in a rate cut in 2020.

As such, fixed-income decisions taken last year warrant a rethink, in our opinion.

Figure 1: Interest rate expectation 12 months out
Chart shows the market implied average overnight interbank interest rate expected for one-month, one year from now. OIS: Overnight indexed swap. Data as of April 4. Source: Bloomberg.

What investors want from fixed income

In reviewing fixed-income allocations, we think it is important that investors remember two of the primary reasons for investing in the asset class: diversification from equity risk and income generation.

Even in a rising rate environment, the income component paid out by intermediate-term bonds helps mitigate the price impact from rising yields. Generally speaking, bonds with longer durations have a higher yield (risk-free rate plus credit spread) and therefore generate a higher degree of income. This is reflected in the outperformance of the intermediate-term fixed-income category versus ultrashort fixed income on a total return basis over the past 15 years. (See Figure 2.)

Figure 2: Behavior of ultra-short versus intermediate-term fixed income
15-year as of 12/31/18 Returns Sharpe Ratio Avg. Drawdown
60% S&P 500/
40% Intermediate-term fixed income
6.4% 0.65 2.61%
60% S&P 500/
40% Ultra-short fixed income
5.7% 0.57 2.76%
Source: Bloomberg as of Dec. 31, 2018.

Additionally, over the same time period, intermediate-term fixed income has delivered a greater diversification benefit from equity volatility compared with ultrashort fixed income, particularly in down markets.

(More: Active vs. passive: The case for both)

It is not our base case that we are heading toward an imminent recession or a Fed rate cut. But we believe the U.S. economy is slowing to around trend growth, which over the past decade is growth of about 1.9% per year according to Trading Economics.

However, if the Fed shifts toward policy easing (either a rate cut or renewed asset purchases) in the not too distant future, then having duration exposure in fixed-income allocations could provide an important source of ballast against potential equity market volatility. (See figure 3.)

Figure 3: Correlations versus domestic equities over past 15 years
Source: Bloomberg as of Dec. 31, 2018.

There may be a number of reasons investors moved into ultrashort duration products last year. But if they did so to shelter from rising interest rates — a thesis that may no longer be valid — then we believe now is the time to revisit that trade.

(More: Smart money is pouring into fixed income)

Gautam Khanna is senior portfolio manager at Insight Investment, a BNY Mellon company.


What do you think?

View comments

Upcoming event

Nov 19


New York Women Adviser Summit

The InvestmentNews Women Adviser Summit, a one-day workshop now held in six cities due to popular demand, is uniquely designed for the sophisticated female adviser who wants to take her personal and professional self to the next level.... Learn more

Most watched


Young professionals see lots of opportunity to reinvent the advice experience

Members of the 2019 InvestmentNews class of 40 Under 40 have strategies to overcome the challenges of being young in a mature industry.


Young advisers envision a radically different business in five years

Fintech and sustainable investing are two factors being watched closely by some of the 2019 class of InvestmentNews' 40 Under 40.

Latest news & opinion

New Jersey fiduciary rule: Pressure leads to public hearing, comment deadline extension

Industry push results in chance to air grievances on July 17 and another month to present objections.

InvestmentNews' 2019 class of 40 Under 40

Our 40 Under 40 project, now in its sixth year, highlights young talent in the financial advice industry. These individuals illustrate the tremendous potential of those coming up in the profession. These stories will surprise, entertain, educate and inspire.

Galvin to propose fiduciary rule for Massachusetts brokers

The secretary of the commonwealth is proposing a fiduciary standard in response to an SEC investment-advice rule he views as too weak.

Summer reading recommendations from financial advisers

Here are some books that will keep you informed and entertained during summer's downtime

4 strategies for Roth conversions

There's never been a better time to do a Roth conversion, and here are several ways to go about it.


Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting investmentnews.com? It'll help us continue to serve you.

Yes, show me how to whitelist investmentnews.com

Ad blocker detected. Please whitelist us or give premium a try.


Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print