Impacts of Chasing Yield with an Inverted Curve

In fixed income, it is generally understood that bondholders are paid more to lend for longer, but with an inverted yield curve, this theory is being put to the test. How then, should investors position their short-term reserves in the current environment? Pile into money market funds which are currently outyielding short duration bond funds? Based on our analysis, the answer is not so simple. Hear from Merganser team members Alli Morse, Relationship Manager, as she interviews Todd Copenhaver, Deputy Chief Investment Officer and Portfolio Manager. Together, they review historical performance of ultra-short and short duration bonds and explore the opportunity cost of allocating to each in various market environments. 

Transcript

Jeffrey Addis:
Welcome to our podcast. My name is Jeffrey Addis. I'm the Chief Operating Officer of Merganser Capital Management. Before we begin, a few important regulatory disclosures. This presentation is for informational purposes only and should not be considered as an investment advice or a recommendation of any particular issuer, security, strategy or investment product. Now on to our podcast.

Alli Morse:
Hi everyone, and welcome to A Bird's-Eye View of the Bond Market with Merganser Capital Management, where we invite leaders from our investment team to offer their analysis on the US investment grade bond markets and insights into key economic developments. My name is Alli Morse and I'm a Relationship Manager here at Merganser, and I'll be hosting today. I'm thrilled to have Todd Copenhaver join me today, who is our Deputy Chief Investment Officer and Portfolio Manager. Welcome Todd.

Todd Copenhaver:
Thanks, Alli.

Alli Morse:
As a fixed income boutique with deep roots and short duration, Merganser has received more than its fair share of questions around the front end of the yield curve during this unique rate environment, we recently published a white paper on the history of short and ultra-short duration. Can you discuss some of these findings a bit more?

Todd Copenhaver:
We analyzed the returns of one-to-three-year treasuries and one-to-three-month treasuries to explore how the returns have compared over the last 30 years with a particular focus on what the during and after looked like for periods of negative returns. Long story short, one-to-three-year, which has a comparable duration to a traditional short duration fixed income strategy, pretty meaningfully outperformed one-to-three-month treasuries, which is a reasonable proxy for money market returns. Most notable, following the experience of 2022 where short duration returns were challenging, the period after a trough in returns tends to exhibit above average returns.

Alli Morse:
So why are we here again looking at a study of short duration returns for the last 30 years?

Todd Copenhaver:
The exploration of short duration returns that we conducted proved to be a bit too bountiful to be contained in one piece. What can I say? I love to talk fixed income. More seriously, as we conducted that research, we were also thinking about the questions we were receiving from clients and consultants about how high money market yields were and whether it made more sense to shorten duration for those current yields. Said another way, wanting to time the market, as self-described, rate agnostics, not looking to make big interest rate bets, we felt like we needed to test our philosophy. To do this, we took the same return series we used for our paper, the Bloomberg one-to-three-month treasury index and the Bloomberg one-to-three-year treasury index for the last 30 years broken up into five year periods. We then applied various algorithms for shortening duration to see if there were certain strategies that might improve outcomes.

Alli Morse:
So as a baseline between the two indices, what did those returns look like?

Todd Copenhaver:
As you might expect from a traditional risk reward framework where lending for longer provides higher returns, that did come through in the data, one-to-three-year returns were on average about 36% higher than one-to-three-month returns. So by buying longer duration bonds, you were getting paid more, and this held for most market periods.

Alli Morse:
That makes intuitive sense. You're generally paid more to lend for longer, but there are some times where you aren't paid much more or even less, which happens to be now as a yield curve is currently inverted. That must be a good time to shorten duration, right?

Todd Copenhaver:
That's not quite what we found. We found that using curve inversion as a signal to shorten was actually one of the worst things you could do. By shortening the moment that the curve inverted, you had the worst performing algorithmic strategy. The only thing that would be worse would be money market funds consistently. We did find that waiting for a deeper inversion showed some promise, but not consistently enough to make us change our strategy.

Alli Morse:
What about when the overall level of rates is low when you aren't giving up that much in income overall?

Todd Copenhaver:
So we looked at this a few different ways. We looked at both low levels of two-year rates, as well as low levels of overnight rates, like fed funds, to see if there were any consistent signals from that. For low two-year rates. That was actually second best if the two-year was under 25 basis points, that that was second to just being consistently in short duration, but it was also the second worst performing strategy in 2022. So while overall it did okay, it did not tend to outperform consistently. For low levels of fed funds, we did find that that performed well in recent history like the last five years, but the period before that, from 2008 to 2018, it did vary poorly, and those gains seen in the last five years more than fully offset by the performance during 2008 to 2018.

Alli Morse:
These results are all really interesting, but in practice, what does this mean?

Todd Copenhaver:
So in practice, this means the timing of the market is rightfully described as humbling. The fact that even what would seem like clear signals to shorten like low levels of income, lower yields, getting paid less to lend for longer, those don't consistently improve returns. In fact, quite the opposite.

Alli Morse:
So it's settled, just go long.

Todd Copenhaver:
Well, let's not get too carried away here. We remain firm believers in the importance of asset allocation in determining interest rate exposure rather than headline yields, a belief only strengthened by this research. For those liquidity needs that aren't measured in days or months, we believe short duration is the proper fit.

Alli Morse:
That's a great point. Ultra-short duration, strategies and money market funds play a pivotal role for the day-to-day liquidity. But should an investor have excess cash beyond operational needs, there are benefits to allocating to a short duration strategy. Thanks Todd, for sharing with us this interesting analysis on the benefits of short duration, and most importantly, thank you to all of our listeners of the Bird's Eye View of the Bond Market.

Jeffrey Addis:
This commentary contained or incorporated by reference certain forward-looking statements, which are based on various assumptions, some of which are beyond our control. Opinions and estimates offered constitute our judgment and are subject to change without notice as our statements of financial market trends, which are based on current market conditions. No part of this presentation may be reproduced in any form or referred to in any other publication without the express written permission of Merganser Capital Management. For more information, please visit our website at www.merganser.com. Thank you.