Today investors can get better returns on money invested for near-term needs than they could during the era of zero interest rates from 2008 through 2015.
Short-term fixed income investments are relatively stable, as well, making them more attractive given the recent increase in stock market volatility.
Not all investments are created equal, so make sure your short-term investments are actually rewarding you with higher income payments.
Now that short-term interest rates have moved up, investors can get better returns on money invested for near-term needs than they could during the era of zero interest rates from 2008-2015. Moreover, the recent increase in stock market volatility may make these relatively stable investments even more attractive to investors seeking to avoid sharp ups and downs. We’ll discuss some investments that allow investors to take advantage of higher interest rates without taking on too much interest rate risk or credit risk.
Short-term yields are up
Most bond yields have risen—but have you been rewarded with higher income payments? Just because short-term bond yields have risen over the past few years doesn’t mean that all short-term investments have rewarded investors with a reciprocal rise in yield.
We always like to point out that there isn’t just one interest rate or one bond yield. There are different types of bonds, and different types of maturities, and they don’t always move in sync. In fact, the slope of the yield curve—the difference between short- and long-term yields—has flattened lately. As the chart below illustrates, short-term rates have risen by a lot more than long-term rates over the past year. To get a yield above 2% today, for example, investors can simply invest in a 1-year Treasury bill. Just one year ago, you’d need to invest in Treasury security with seven years to maturity to get a similar yield.
We think this is important—you don’t need to take on as much risk to get higher yields today compared to the past few years.
Today you can take less risk to earn higher yields
Source: Bloomberg, data as of 4/3/2018. Past performance is no guarantee of future results.
Shown differently, we can see below that short-term yields have risen by a lot more than long-term yields over the past year. Short-term rates tend to follow the trajectory of the federal funds rate, but long-term rates are driven more by growth and inflation expectations. Despite the recent Fed rate hikes, growth and inflation expectations have only risen modestly, leading to smaller increases in long-term bond yields.
Short-term yields have risen more than long-term yields
Source: Bloomberg. Yield change based on Treasury curve tenor, from 04/03/2017 to 04/03/2018. Past performance is no guarantee of future results.
Let’s take a look at some investments that may offer higher yields today:
1. Ultrashort bonds
According to Morningstar, ultrashort bond portfolios are those which “invest primarily in investment-grade U.S. fixed income issues and have durations typically of less than one year.” 1 U.S. Treasury bills would be considered high-quality ultrashort bond investments.
Treasury bill yields tend to track the federal funds rate, so they’ve been on the rise as the Fed has boosted its benchmark rate six times since December 2015. It’s true that yields are still well below pre-financial crisis levels, but it’s still hard to ignore how much higher they are today compared to the years immediately following the crisis. At the close of the first quarter of 2018, the average yield-to-worst of the Bloomberg Barclays Treasury Bill Index was 1.8% (“yield to worst” is the lowest potential yield that can be received without the issuer defaulting—it’s the lower of the yield-to-maturity or the yield the investor would receive if the issuer prepaid or “called” the bond). From 2009 through 2015, the average yield-to-worst was just 0.10%.
Treasury bill yields have risen
Source: Bloomberg, using monthly data as of 03/30/2018. Past performance is no guarantee of future results.
2. Short-term bonds
According to Morningstar, short-term bond portfolios “invest primarily in corporate and other investment-grade U.S. fixed income issues and typically have durations of 1.0 to 3.5 years.” 2 These types of investments have slightly more interest rate risk than ultrashort bonds, but today they also offer slightly higher yields.
As the chart below illustrates, the Bloomberg Barclays U.S. Treasury 1-3 Year Index offered a yield-to-worst of 2.3% at the end of the first quarter of 2018—it was as low as 0.62% as recently as July 2016. As shown above, the slope of the yield curve is still upward sloping, and so investors can earn slightly higher yields by investing in bonds with maturities that are slightly longer than those offered by Treasury bills. For investors who are looking for short-term investments, but don’t necessarily need the funds in the next 12 months or so, short-term bonds can offer slightly higher yields in exchange for a little more interest rate risk.
One- to three-year yields have risen
Source: Bloomberg, using weekly data as of 03/30/2018. Past performance is no guarantee of future results.
3. Short-term municipal bonds
Investors in higher tax brackets may want to consider short-term municipal bonds versus other short-term taxable alternatives, as well. Short-term municipal bonds, like municipal bonds in general, usually pay interest income that is exempt from federal and potentially state and local income taxes. As of April 3, 2018, the yield-to-worst for the Bloomberg Barclays Municipal 1-year (1-2) Bond Index was 1.8%. For an investor in the highest tax bracket this is equivalent to a yield of roughly 3.3% for a taxable bond after accounting for federal and state taxes. 3
4. Investment-grade floating-rate notes
Investment grade floating-rate notes, also called “floaters,” don’t have their own Morningstar category. However, funds that invest in floaters generally fall under the “ultrashort” category. Investment-grade floaters are a type of corporate debt whose coupon rate is based off a short-term benchmark—usually the three-month London Inter-bank Offered Rate (LIBOR)—plus a spread. Since these are issued by corporations, they have additional risks compared to U.S. Treasuries, like the risk of default.
Investment-grade floaters offer two key benefits, in our opinion: coupons that can adjust upward as short-term interest rates rise, and relative price stability.
The common reference rate, 3-month LIBOR, is highly correlated to the federal funds rate. Floater investors generally get rewarded with higher coupon payments as short-term rates are on the rise.
Floater coupon rates have risen along with the federal funds rate
Source: Bloomberg, using weekly data as of 3/31/2018. Bloomberg Barclays U.S. Floating-Rate Notes Index and federal funds rate midpoint of range. Past performance is no guarantee of future results.
And floater prices tend to be stable regardless of the interest rate environment, unlike fixed-rated bonds whose prices fall when their yields rise. When short-term rates rise, floater prices don’t need to adjust because their coupon rates already have. Keep in mind that investment-grade floaters can experience price volatility due to credit concerns—they are corporate bonds, after all—and during a recession or a financial crisis their prices could fall sharply.
Floater prices have been relatively stable even as short-term rates have risen
Note: While the market value of a floating rate note is relatively insensitive to changes in interest rates, the income received is highly dependent upon the level of the reference rate over the life of the investment. Total return may be less than anticipated if future interest rate expectations are not met.
Source: Bloomberg and Barclays. Daily data as of 4/3/2018. Bloomberg Barclays U.S. Corporate 1-5 Year Bond Index and Bloomberg Barclays U.S. Floating-Rate Note Index. Past performance is no guarantee of future results.
What to do now?
Make sure your short-term investments are actually rewarding you with higher income payments—and if you’re becoming leery of a volatile stock market, consider whether you might prefer to allocate a portion of your portfolio to short-term investments like the ones described above. We all know that not all bonds are created equal, but that’s the case with short-term investments too. If you’ve been waiting on the sidelines to invest in higher yields, we’d ask “what are you waiting for?” and “If you are waiting, what are you earning while waiting?”
1Source: “The Morningstar Category Definitions,” Morningstar, April 29, 2016.
3Assumes a 37% Federal tax rate, 5% state income tax rate, and 3.8% tax on Net Investment Income (NII). Source: Bloomberg Barclays 1-year (1-2) Municipal Bond Index, as of 4/3/18.
What You Can Do Next
Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
Explore Schwab’s views on additional fixed income topics in Bond Insights.