Shorter bonds, safer bets?

INVESTORS are finding themselves in an awkward spot: bond yields are climbing to levels that could eventually pressure equities, yet the attraction of stocks remains hard to shake.

At the same time, some of the world’s biggest fixed-income investors are quietly reducing their exposure to long-dated government debt and moving towards shorter maturities, inflation-linked securities and credit.

According to Bloomberg reports, the split reflects a market trying to balance two competing forces – the prospect of further gains in equities and the growing risk that inflation, government borrowing and geopolitical tensions could keep bond yields elevated for longer.

For now, professional investors are still remarkably bullish on stocks.

The newswire pointed to Bank of America Corp’s latest survey of global fund managers showing that equities account for 56% of portfolios, the highest proportion since November 2021.

That is despite respondents identifying a “disorderly rise in bond yields” as the second-largest threat to the equity market, behind concerns about an artificial intelligence (AI) bubble.

Inflation is another worry, with 25% of respondents naming a second wave of inflation as the biggest risk.

“The elephant in the room” is the rise in yields, according to Bloomberg, citing Tyler Richey, editor of the Sevens Report Technicals newsletter.

The concern is straightforward: as government bonds offer increasingly attractive returns, investors may eventually demand a bigger premium to keep holding riskier assets such as shares.

Yet, so far, that tipping point has not arrived.

“You should be bullish, or at least opportunistic here,” JC O’Hara, chief technical strategist at Roth Capital Partners LLC, tells Bloomberg, in reference to the stock market sitting near record highs despite climbing yields.

He points to stronger earnings expectations, a better economic outlook and a lighter focus on Middle East tensions as reasons for improving risk appetite.

That leaves investors watching yields closely, but not necessarily running for the exits.

Sweet spot

For equity investors, the shape of the yield curve may be just as important as the absolute level of yields.

Ed Clissold, chief US strategist at Ned Davis Research, describes the current yield curve as a “sweet spot” for equities, Bloomberg reports.

As of last week, the 10-year Treasury yield was about 49 basis points above the two-year yield, producing a modestly upward-sloping curve.

According to Ned Davis Research analysis going back to 1976, a yield curve where the 10-year yield is as much as 1.5 percentage points above the two-year yield has historically been associated with some of the largest and most consistent gains for the S&P 500.

In that range, the index has delivered an average annual return of roughly 11%.

But there is a level where even the most optimistic stock investors may start to get uncomfortable.

“We’re OK around here, I think a move closer to 5% probably is the thing that would rattle the market, akin to what happened in 2023,” Liz Ann Sonders, chief investment strategist at the Schwab Center for Financial Research, says in a Bloomberg TV interview.

That warning is not theoretical. In 2023, the S&P 500 fell 10% between the end of July and late October as the 10-year Treasury yield surged and briefly touched 5%.

“Bond yields start to move higher and the equity market ignores it – until it doesn’t,” Matt Maley, chief market strategist at Miller Tabak + Co, is quoted as saying to Bloomberg.

For bond investors, however, the strategy is already shifting.

Duration matters

According to a separate Bloomberg report, some of the world’s biggest investors have already been flocking to short-dated bonds as a selloff hits longer-maturity government debt.

The move is partly about avoiding a repeat of 2022, when the war in Ukraine, an inflation shock and aggressive interest-rate increases inflicted double-digit losses on government bonds.

Among them are BlackRock Inc, Aviva Investors, Aegon Asset Management and Allspring Global Investments.

“Opting for bonds with shorter maturities, including credit, instead of long government debt is probably ‘the most consensus trade’ now,” Lauren van Biljon, a portfolio manager at Allspring, tells Bloomberg. “It’s also worked very well.”

The numbers back up that positioning.

Morningstar data shows investment managers have been cutting the maturity of their debt holdings for months.

UK multi-asset funds held fixed-income securities with a median effective maturity of 5.33 years at the end of June, down from 5.55 years at the end of December.

That compares with 8.16 years for a Bloomberg global debt index.

The attraction of the short end is becoming clearer as inflation and interest-rate risks remain elevated.

As in 2022, the outbreak of war in the Middle East in February triggered a sharp rise in energy prices and bond yields.

That has weakened the traditional role of government bonds as a defensive asset.

“The short end of the government bond curve is probably the safest place I can put my money when I want to not worry,” Vera Fehling, Europe chief investment officer at DWS, tells Bloomberg.

Performance has supported that view.

A Bloomberg gauge tracking bonds with maturities of one to three years has gained 1% this year, compared with a 4% loss for bonds with maturities of 10 years and longer. An index of US Treasury bills is up 2.3%.

The reason is simple enough. Longer-dated bonds are far more sensitive to changes in interest rates. When yields rise, their prices have to fall more sharply to compensate investors for the lower coupons attached to existing securities.

That makes duration – essentially, sensitivity to interest-rate movements – a risk that many investors are increasingly unwilling to carry.

“Shorter maturities make sense, particularly for more cautious multi-asset portfolios where historically the allocation might have been 80% fixed income.

“Unless that’s held in a very short duration manner, that is a lot of duration and sensitivity to inflation and interest rates,” Sunil Krishnan, head of multi asset funds at Aviva Investors, tells Bloomberg.

The inflation backdrop is also making longer-term bonds less comfortable to own.

“We do now seem to be in a more inflationary environment, not hyperinflation. But with a couple of wars, tariffs, throw in reshoring, net-zero, and more recently large amounts of AI infrastructure spending.

“In the near term these things are all adding to inflation. We certainly feel more comfortable with shorter-dated bonds than longer duration,” Colin Dryburgh, multi asset investment manager at Aegon, tells Bloomberg.

There is another reason investors are willing to take some credit risk instead.

With companies still relatively flush with cash and economic growth holding up, some investors see corporate debt as a better bet than taking on large amounts of interest-rate risk through long-dated government bonds.

Charlie Lloyd, chief investment officer at Shackleton, says his funds are underweight government bonds and have been buying asset-backed securities with floating rates and “no duration exposure whatsoever”.

“It’s all very well owning sort of shorter-dated instruments like high-yield bonds at the moment,” Lloyd says.

“If corporate fundamentals were to deteriorate from here, then obviously spreads would widen and government bonds would hold up better in that environment,” he tells Bloomberg.

James Turner, BlackRock’s head of global fixed income, EMEA, says in an Aug 7 interview with Bloomberg TV: “Short-term government bonds have good yields at the moment and we’re happy having that.”

“We don’t really want the term premium risk because of the continued issues we see in geopolitical risk and also uncertainty at the long end,” he adds.