Riding the Curve

Danny Sarnowski: Welcome. Thank you for joining me today on LinkedIn. I'm Danny Sarnowski and I'm a fixed income portfolio specialist at Allspring Global Investments.

Bond investors today are facing a dramatically different environment than they've seen for the last two years and, indeed, for most of the last 20 years. The landscape has materially shifted and unless investors consider ways to take advantage of this new market landscape, I think they face substantial opportunity costs—costs worth considering.

The good news is that there are strategies that I think investors can employ, which will mitigate or help avoid these opportunity costs and help them take advantage of what's on offer today. So, what's changed? Well, in a word, yields. Income. It's a bit cliché already to say, but there is income back in fixed

Remember, as a bond investor, when we buy a bond, we're making a loan. We're a lender. And when we lend somebody money—most often, the government, a corporation, or maybe a local municipality—we want our money back at maturity—at par, the original price that the bond was issued at—but we also want to earn income or yield for extending that loan. And for most of the last 16 years since the Financial Crisis, the amount that lenders could earn was very, very low. That made it a difficult environment for bond investors. There wasn't much yield on offer because in the aftermath of the Great Financial Crisis of 2008, the U.S. Federal Reserve (the Fed), our central bank, and central banks around the world lowered interest rates in an effort to stimulate the economy and help them recover.

When central banks lower rates, what they're trying to do is encourage borrowing. They want to make it cheaper for people to buy a car, get a mortgage, or use a credit card. and low yields and low rates are great news if you're a borrower. But they're not great news if you're a lender or if you're a bond investor who's hoping to earn income from making those loans. From 2015 to 2018, the Fed did raise rates a little bit. They got them up off of zero, but in the onset of the COVID pandemic, they returned them back to between zero and a quarter of 1% or 25 basis points. One basis point is 1/100 of a percent. So, you can see they were very low and they stayed low for many years.

But as the U.S. and the world recovered from the pandemic, central bankers saw a significant rise in inflation. And one of the ways they can fight inflation is to raise interest rates. They want to increase the cost of borrowing to slow economic conditions and bring inflation under control. The process of yields going from very, very low to much higher is a painful one for bond investors because as yields rise, bond prices fall. They have an inverse relationship.

And so, when the Federal Reserve raised rates in the last two years, they did so faster and by a greater degree than they've done in more than 40 years. And bond investors felt that pain of the highest, fastest increase in rates in decades, which resulted in the worst price declines that bond investors have seen in that same amount of time.

But now? Now that yields are high, the landscape from here is very, very different. Let me show you what I mean. What I'm showing you here on the screen is the U.S. Treasury yield curve. Now, the yield curve is just a line that represents how much an investor would get paid in yield to buy a Treasury security, basically to lend the U.S. federal government money for various maturities from 30 days or one month, all the way out to 30 years. And if you're looking at the screen, the blue line on the bottom of the page, that line represents the average yield that investors got paid at each one of those maturities over the last 15 years. So, looking at the lower left, what you're seeing is that first stop on the blue line represents that investors earned just under 1% on average over the last 15 years to lend the U.S. federal government money for a month or to buy a four-week Treasury bill. But the purple line at the top of the chart is the Treasury curve as of the end of April. And what you can see is that an investor today who buys a four-week T-bill and loans the U.S. federal government money can expect a yield of over 5%, more than five times as much income, massively more income or yield on offer for the same level of risk over the same time period.

Because of what the Fed has done, raising rates on the very front end, and because the market follows suit and yields out the curve have risen, what you see on that purple line is that yields across the entire curve are much, much higher today than they've been for most of the last 15 years or since 2008. And that's good news if you're a bond investor. Also, when the yield curve is high and flat like this, it tells me that there's a broad range of possible economic outcomes from here.

But what we're finding is that investors responded to the increase in yields on the front end of the curve by getting prepared for more and more rate hikes, which, in our opinion, is not the most likely outcome from here. Now, I can show you that on this chart. This is the growth of money market mutual fund assets in the industry over the last 30 years. That's the blue area chart. Money market funds are very, very, very short-term and very high-quality fixed income portfolios. Retail and government funds trade with a stable $1 NAV or share price. And because they're so short maturity, as yields rise, the yields that those money market funds are able to offer quickly rise, as well. And so, it makes sense in a rising rate environment that investors would choose to use money market funds. And if you're looking at that area chart, you can see that the money market funds in the industry have grown by almost 50% in just the last four years, reaching an all-time high this year of over $6 trillion. What you'll also see on the chart is the purple line. That's the federal funds rate. That's the policy rate that the Fed uses to adjust monetary policy. And you can see that for much of the time since 2008, that line was very, very low—nearly zero. And if you're looking at the far right hand side, you can see it's sort of screaming higher over the last two years to more than 5.25%. So, it would make sense that investors found value in the very front end of the curve because that's where yields were rising. But you'll also note that the purple line, while it's high today, doesn't just stay static. Rates go up, they stay static, and they can come down.

And so, what investors face today is the conundrum, if they're sitting, let's say, on the very front end of the yield curve, is that they have the opportunity to lock in rates across the yield curve that I showed you earlier for a longer period of time before yields fall again. And when I talk to investors, many of them will say they know this and they plan on doing it. But it's a very difficult question to consider when to do so. It's challenging to figure out what that perfect time is. And many of them sort of get locked with inertia because they don't know when to move. They're waiting for some Goldilocks moment, some perfect moment where moving out across the curve will feel just right. And market timing is always very challenging, but I think it's even more difficult when you're trying to time something like the U.S. Federal Reserve. The Fed doesn't lower rates just to be nice. They lower rates because they're trying to stimulate the economy after some shock has brought the economy lower. They're trying to stimulate growth and help us recover. And that can be difficult to forecast. Things like the Financial Crisis in 2008, the tech bubble bursting in the early 2000s, or the onset of COVID in 2020 would be very difficult to look ahead and forecast and plan to take advantage of higher rates right before they fall.

I think a better plan is to lock in some of these longer maturity bonds ahead of time. Now, if you could market time, if you could perfectly time it, you’d do well because as yields fall, bond prices rise, right? That inverse relationship. And what I'm showing you here is the last four times that the Federal Reserve did lower rates. During the period when they were cutting rates, what was the total return experience for different fixed income investors? The first row you'll see there is 3- to 6-month Treasury bills. And I'm using that as a proxy for money market funds. Remember, very, very short-term, very, very high-quality securities. The next row is people who invested at the 1- to 3-year spot along the Treasury curve. The next row is people in the Bloomberg U.S. Aggregate Bond Index. That's an index that invests not just in Treasuries, but mortgages and investment-grade corporate bonds, as well. And then, the 10-year Treasury is the next row. And as you can see, each time when yields are falling, investors who had stepped out along the yield curve saw higher total returns than those who had just stayed in the shorter Treasury bills or who stayed on the front end of the curve. But the row that I think is the most interesting one is the bottom one. That's a diversified portfolio and it's just a hypothetical portfolio where I took 25% and equally weighted in each of the other four rows. So, 25% in T-bills, 25% in the front end of the curve, the U.S. Aggregate Index, and the 10-year Treasury. And what you're going to see is, again, in each time when yields are falling, that diversified portfolio also outperformed those who stayed in Treasury bills on the very, very front end of the curve. And I think that's good news for investors to know today because it means there isn't one perfect spot on the Treasury curve or one maturity where they need to make a major shift from the front end to something else and go all in at just the right time. I think that they don't need to have that stress.

Importantly, what I found is that in periods when the Fed has been raising rates before they cut them, the market tends to anticipate that the Fed will begin to cut rates. And that's the period I call the “Waiting for Goldilocks” period. And that's what I've used as the peak of the 10-year Treasury yield to the period before the Fed actually begins cutting. And even before the Fed begins to cut rates, we see the same thing that we saw on the prior chart. And that's that investors along the curve have earned higher total returns than those sitting on the very, very front end because that expectation for lower yields by the market led to higher prices for investors who had stepped out across the curve.

Again, what this is telling me is good news. It’s that there isn't one perfect moment where you need to make a big shift or else you'll really miss out. But investors who did stay invested on the very front end in those T-bills underperformed that diversified portfolio in each of these prior periods. In fact, those cash-only investors, those Treasury bill investors, earned 60% less on average than that diversified portfolio that I showed you. That's a sizable opportunity cost for staying just sort of huddled in the front end and being caught by inertia, waiting for something to change.

And so, I think the opportunity here for investors, whether they're managing their own portfolio or working with an advisor or financial professional, is to consider a plan for how to exploit that yield environment we have today, where yields are high just about everywhere. And one strategy I think that can add value is what we at Allspring call “Riding the Curve.” And all that means is diversifying exposures across the curve. It frees investors and advisors up from trying to pick that perfect Goldilocks moment or trying to pick one spot along the curve to make a big all-in bet. Instead, it lets them say, let's put a plan in place, let's diversify our duration and be really thoughtful about where and how we take risks in the bond market today, and give ourselves quite a bit of flexibility.

And personally, I think it helps build more resiliency into the portfolio, as well, so that as yields change, as either the Fed starts to lower rates or as markets start looking forward to policy adjustments, investors are going to get the advantage of that and not face those opportunity costs of being stuck waiting for Goldilocks. Now, I really appreciate your time this morning. I hope you found value in the content. For more information about how to take advantage of the current market environment or for more of our insights, please reach out to your financial professional, contact your Allspring Regional Director, or visit us at allspringglobal.com.