By Timothy Urbanowicz, CFA®, Senior Fixed Income ETF Strategist
Time to read: 3 min
Credit investors faced many headwinds in 2018 as financial conditions tightened, foreign demand faded and spreads widened. Despite support from a booming economy and strong earnings growth, most credit sectors saw negative total returns. Today, many challenges remain, and the growth tailwind may be fading. But there is a certain type of fixed income strategy that may help mitigate the effects of market volatility and provide investors with an attractive opportunity — defined maturity bond funds.
A flatter yield curve. Last year as expected, the Federal Reserve (Fed) pushed rates higher and shrank its balance sheet. Rates on 1-year and 2-year Treasuries rose about 50% and 30% respectively, rates on 5-year and 10-year Treasuries rose about 13%, and rates on 30-year Treasuries rose about 10%.1 As shown in the chart below, this had a flattening effect on the yield curve, pushing the spread between 2-year and 10-year Treasuries to just 20 basis points to close the year — about 84% below the historical average.
What does a flatter yield curve mean to credit investors? With a flatter yield curve, there is less compensation for investing in longer-maturity bonds because these coupons are only slightly higher than those of short durations. This makes the short end of the curve (one to three-year issues) more attractive.
Source: Bloomberg L.P. as of Dec 31, 2018. Data from March 31, 1977, to Dec 31, 2018, from Market Matrix. US Sell 2 Year Buy 10 Year Bond Yield Spread
On the other hand, in 2018 the investment grade credit curve steepened, as non-US demand for corporate bonds dropped, concerns over a global growth slowdown rose and perceived credit risk increased. Strong US pension demand, however, did help tether the longer maturities by keeping these issues well bid. Pension buying of corporates in the first half of 2018 alone accounted for four times the inflows seen in all of 2017.2
Widening spreads. In February 2018, the spread between investment grade bonds and Treasuries hit their tightest level for this cycle, and the spread between high yield bonds and Treasuries followed suit in October. However, both spreads widened with the December uptick in volatility. Investment grade spreads now sit 12% above their historical median while high yield spreads sit 6% below historical median levels (dating back to 2010).1
Given that the Fed is now willing to consider all appropriate policy actions (presumably including rate cuts), investors certainly are less fearful of rising rates in the near term. However, it is very likely that any rate cuts this year will be due to deteriorating economic conditions from trade conflicts or other factors.
With all of the uncertainty around rates, credit spreads and growth, investors may be inclined to look to defined-maturity bond funds. Unlike traditional fixed income funds that tend to sell bonds before their maturity dates, defined-maturity funds seek to hold securities through final maturity — at that time, investors can take the proceeds from the maturing bonds or reinvest the proceeds in a different ETF with a new maturity date.
By rotating into a defined maturity vehicle (such as Invesco’s BulletShares exchange-traded funds), investors may be able to help mitigate market noise and associated volatility. If rates go up and spreads widen, investors have the option to hold their fund investment until it matures. If rates drop, investors have exposure to credit markets and can either continue receiving their (above-market) coupons, or they can sell and possibly capture the appreciation in their position from the credit rally.
BulletShares defined-maturity ETFs are available across the yield curve, so investors can efficiently ladder a portfolio. A ladder is a portfolio of bonds that mature at staggered intervals across a range of maturities. Assuming rates rise, proceeds from each maturing rung of defined maturity ETFs can be reinvested in longer-dated funds at higher rates. If market rates fall or remain flat, fund holders can stay invested and take the proceeds when the funds mature.
Learn more about Invesco BulletShares ETFs.
1 Source: Bloomberg L.P. as of Dec. 31, 2018
2 Source: Sources: Federal Reserve, Wells Fargo Credit Strategy and Bloomberg L.P. as of Sept. 28, 2018.
Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
Yield spread is the difference between yields on differing debt instruments, calculated by deducting the yield of one instrument from another.
The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity. The “short end” of the curve refers to bonds with shorter maturity dates.
A flat yield curve is one in which there is little difference in the yields for short-term and long-term bonds of the same credit quality. In a normal yield curve, longer-term bonds have a higher yield.
Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates. Duration is expressed as a number of years.
The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.
Maturity is the date on which a debt security becomes due and payable.
A basis point is one hundredth of a percentage point.
Your email has been submitted. Thank you!
Form submission failed!
Please check the box to confirm you are not a robot. Thank you.