Tapping Today’s Opportunity in Short-Dated Corporate Bonds

• Front-end yields remain above the likely range associated with neutral monetary policy in the US and Europe, creating an opportunity to generate high yield through a portfolio of short-dated investment grade corporate bonds.

• We believe investors should focus on four key areas when evaluating the front end of the corporate credit curve: yield enhancement, relative value, diversification, and liquidity.

• We view global diversification and looking beyond one’s home market as key to potentially enhancing returns and mitigating risk.

Over the past two years, rate hikes by the Federal Reserve and the European Central Bank have caused yield curves to invert. This has provided investors less compensation for taking duration risk and an opportunity to lock in higher yields with lower interest rate risk at the front end of the curve.

The Front End of the Yield Curve Has Become More Appealing

US Treasury and German Bund Yield Curves: Year-End 2021 – February 2024

Source: Bloomberg as of 29 February 2024.

Members of both the Federal Open Market Committee and the ECB have signaled their intention to cut rates in the coming months, although the timing and pace of those reductions remain uncertain. Inflation in the US and Europe has proven stickier than markets anticipated at the start of 2024, seemingly pushing any potential rate cuts to June or later.

US and Europe Rate Cut Expectations Have Been Pushed Further Out

Futures Implied Rates: Fed Funds and ECB Policy Rates

Source: Bloomberg and PineBridge Investments as of 12 March 2024.

With rates in the US and Europe likely to remain at current levels for another few months, the window of opportunity is still open for investors to take advantage of historically high nominal yields and inverted curves. Short-dated corporate bonds further enhance the carry available to investors and should also benefit from the gradual normalization of the yield curve over the next 12 to 24 months.

Opportunities Persist in Shorter-Dated US and Europe Bonds

US Treasury Index YTW, US IG Corporate YTW and OAS

German Bund Index YTW, EUR IG Corporate YTW and OAS

Source: Bloomberg as of 12 March 2024.

In evaluating opportunities at the front end of the corporate credit curve, we believe investors should focus on four key areas:

1. Yield enhancement

Investors have typically looked to enhance yield in short-dated assets – particularly in periods of low or negative rates – by investing in investment grade corporate bonds. While yields on US Treasuries and German bunds are historically high, we believe investors should not forgo the accretive value that higher-yielding corporate bonds can have on cumulative returns of short-dated positions.

While investing in short-dated corporate bonds is not a new concept in cash management strategies or in short-dated liability matching, investors willing to look outside their domestic bond markets will find even greater potential for enhancing portfolio yield, with pickup in yields that range from 40 to 70 basis points (bps) across different regions. For European investors, investing outside of Europe greatly increases the pool of liquid assets, but the hedging costs of swapping US dollars for euros erodes the yield enhancement of US dollar bonds. After hedging, there is still excess yield in short-dated US dollar bonds issued out of Asia, the Middle East, Africa, and Latin America.

Looking Outside One’s Home Region Could Enhance Returns

Global IG Corporate USD Bond Markets – Yield Curves by Region

Global IG Corporate Bond Markets – EUR Hedged Yield Curves by Region

Source: JP Mogan, Bloomberg and PineBridge Investments as of 19 February 2024. Diversification does not ensure against market loss.

2. Relative value

Valuations across credit markets are tight, and the same can be said for short-dated corporate bond spreads. However, while investors’ return expectations will be rooted in carry, investors can also expect price appreciation from a decline in nominal yields as policy rates and front-end yields normalize.

Global Spreads Are Toward the Lower End of Their Historical Ranges, but Value Exists

1-3 Year Corporate Bonds: 10 Year OAS Range (ex-COVID) and Current OAS

Source: JP Mogan, Bloomberg and PineBridge Investments as of 29 February 2024.

Across the market, short-duration investment grade corporate bond spreads are toward the tight end of their historical range. In Asia, the deep local investor base has been pursuing a smaller pool of assets, as many issuers have turned to local bond markets given the increase in US dollar yields. As a result, Asia-Pacific investment grade corporates have outperformed, but spreads are near their tightest levels of the past decade.

Corporates from Latin America offer value, both compared with other regional bond markets and with their own historical levels, and they appear attractive given expectations that structural economic changes will be supportive of corporate borrowers in the region.

When evaluating relative value, investors must consider index composition, particularly as it relates to credit quality. While index spreads suggest Asia-Pacific and US short-dated corporate bonds appear relatively rich, it should also be noted that both markets are higher in quality than their regional counterparts. Within the Asia-Pacific investment grade market, 57% of bonds with less than five years to maturity are rated single-A or higher, in stark contrast to the lower ratings in Latin America.

Credit Quality Varies Across Regions for Bonds With Less Than Five Years to Maturity

Rating Distribution of IG Corporate Bonds With Less Than 5 Years’ To Maturity

Source: JP Morgan, Bloomberg as of 12 March 2024.

While spreads at the index level are tight, we see a wealth of more selective opportunities to further enhance the value of an actively managed short-duration corporate bond portfolio.

Count of Investment Grade Corporate Issuers With Bonds Less Than 5 Years to Maturity

Source: JP Morgan, Bloomberg as of 12 March 2024.

3. Diversification

Taking a global approach to manage short-duration corporate bond portfolios provides exposure to various economic cycles, which can have different impacts on corporate bond performance and diversification of risk among regions. This benefit becomes particularly relevant given the uncertain economic outlook for both the US and the euro area over the next one to three years.

A Global Approach May Offset Middling US and EU Growth

GDP Growth Forecasts by Region (%)

Source: IMF as of 31 December 2023.

A slowdown in US growth will prompt Fed rate cuts and a decline in front-end Treasury yields, which would benefit all US dollar-denominated short-dated corporate bonds. However, whereas slower US growth would have a negative impact on US corporate spreads, Asia corporates would offer greater stability given the higher base levels of economic growth and reduced reliance on US trade for many Asian economies.

4. Liquidity

For many investors, the liquidity of their short-dated fixed income or cash enhancement allocations is an important consideration. It is thus not surprising that the majority of trading in global investment grade corporates is in bonds with tenors between zero and seven years.

Trailing 3 Months Trading of IG Corporate Bonds by Maturity

Source: Bloomberg, Trace as of 29 February 2024.

Liquidity in the front-end market is further supported by the broker-dealer community, where dealer inventories of short-dated bonds has ranged from $1 billion to $6 billion over the past year, compared to long-end inventories that have fluctuated around zero.

Dealers’ Inventories Have Leaned Heavily Toward Short-Dated vs. Long-End Bonds

Source: Federal Reserve Bank of NY as of 29 February 2024.

Any global short-duration investment grade corporate bond strategy must strike a balance between the yield enhancement available outside developed markets with the greater liquidity found within them: The US and euro short-corporate investment grade bond markets each amount to roughly $8 trillion (see chart below). The short-dated global EM corporate bond market is not insignificant, at over $2.2 trillion, with Asia-Pacific a major constituent. The higher-yielding opportunities within the Middle East and Africa and Latin America are from smaller, less-liquid markets.

Balancing Market Size and Liquidity With Yield Enhancement

Total 1 – 5 Year Maturity IG Corporate Bond Stock Outstanding (USD bn.)

Source: Bloomberg as of 12 March 2024.

Tapping historically high yields in short-dated corporate bonds

The compelling case for short-duration credit is grounded in the anomaly that front-end yields remain several standard deviations above the likely range associated with neutral monetary policy in the US and Europe. Investors stand to benefit from higher yields, reduced interest rate risk, and favorable liquidity dynamics in the short end. As we anticipate a normalization of the yield curve, we believe the opportunity to generate high yield through a portfolio of short-dated investment grade corporate bonds is historically attractive.

US Treasury and German Bund 2 -10 Bond Spread (bps)

Source: Bloomberg as of 15 March 2024.

Opportunities are not without risks – but an actively managed portfolio designed to optimize yield within the construct of a well-defined risk expectation can unlock the benefits we’re seeing today in this asset class.