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Goldman Sachs Asset Management Statement on the Russia-Ukraine War. Read it here .

   

May 18, 2022 | Macro Insights

Change in Yield…Change in Fortune?

US Treasury yields—particularly those at the front end of the curve—have risen over the last year in much the way that a character in an Ernest Hemingway novel said he went bankrupt: “gradually, then suddenly.” The corresponding decline in prices in 1Q 2022 was the worst quarterly slide in more than 40 years. But now for some investors, higher yields may add up to attractive opportunities in short-duration strategies.

The macroeconomic outlook remains uncertain. A year ago the market did not expect the Federal Reserve to lift interest rates until 2024.  By last September, expectations had shifted to one 25-basis-point hike by the end of 2022. Today, markets are pricing in more than nine rate hikes, with a few more likely to come in 50-basis-point increments.

This abrupt shift in Fed expectations has driven yields higher across the Treasury curve, giving longer-dated bonds a bigger income buffer against future price declines. But considering the relative flatness of the curve, we see a potentially more attractive opportunity at the front end. Yields on the two-year note have jumped from 0.28% six months ago to 2.63% today. The result: these assets offer a similar amount of income as longer-term Treasuries.  Yet their shorter duration—or interest-rate risk—means they are better protected against future rapid rate increases. When compared to the broader Bloomberg Aggregate Index, a short-duration strategy at current yields offers similar income potential with a fraction of the interest-rate risk.

To put a finer point on it, an investor who purchases a two-year US Treasury note today can expect to earn 2.63% of income. For that investment to begin to lose money over the next 12-months, interest rates would need to rise enough to push the yield above 4.00%.

EXHIBIT 1: Flatter Yield-Curve Creates Value in Short-Term Bonds

EXHIBIT 1: Flatter Yield-Curve Creates Value in Short-Term Bonds

Source: Bloomberg and Goldman Sachs Asset Management, as of May 10, 2022. The chart shows yields for the 2-, 3-, 5-, 10- and 30-year maturities on the US Treasury yield curve as of May 10, 2022. Past Performance does not guarantee future results, which may vary.

Long duration bonds – Treasuries, corporate bonds and other high-quality securities, remain in our view an essential part of a diversified fixed income allocation. These assets can help cushion markets through price appreciation during sudden bouts of risk-off sentiment and market drawdowns1. But we believe the increased income potential of short-duration strategies may be particularly attractive.

To be clear, interest rate risk remains elevated, and the Fed may decide to hike rates more aggressively than currently expected. Still from a total return standpoint, we believe the sharp repricing in yields means the front-end of the Treasury curve may offer attractive compensation for the risks involved.

It is possible, of course, that aggressive Fed tightening this year will cause more turbulence in bond markets. Questions about growth also abound: can the Fed raise rates multiple times, including at 75-basis-point increments, without tightening financial conditions enough to suppress activity and hurt employment? When will the “persistence of transitory inflationary shocks” fade? Will long-term inflation expectations remain anchored?

Arguably, in recent history this list of vital policy questions has never been longer, and how they are answered will have implications for the outlook of US Treasuries. Nevertheless, based on what is currently priced in, the recent and abrupt bear flattening of the yield curve has had a meaningful impact on the risk-reward profile for investors, and in our view may have opened up interesting opportunities for short duration strategies2.  We think the time for earning income without taking-on significant interest rate risk has made a comeback.

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ABOUT THE AUTHORS

Davide Andaloro, CFA

Davide Andaloro, CFA

Senior Market and Portfolio Strategist, Strategic Advisory Solutions, Goldman Sachs Asset Management
Matthew Wrzesniewsky

Matthew Wrzesniewsky

Fixed Income Strategist, Goldman Sachs Asset Management

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