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February 09, 2021 | GSAM Connect

How Short Duration Bonds May Ease the Low-Yield Blues

Tired of earning next to nothing on cash? We think short duration fixed income may help boost return potential---as long as investors are prepared to make some tradeoffs.

Faced with what appears to be a lower-for-longer interest rate environment, investors have been starting to roll up the yield curve in search of higher income and returns. Since the coronavirus crash hit in 2020, more than $132 billion has flowed into the Ultrashort and Short Duration bond categories1

And there may be more to come: assets in low-yielding money market funds are still $1 trillion more than they were at the start of 2020 and almost $2 trillion above where they were before the last Federal Reserve hiking cycle2. That’s a lot of cash still sitting on the sidelines.

We believe that investors willing to take on a bit more risk might consider boosting exposure to short-duration bonds. But it’s important to understand that this is not a riskless move. Like many things in life, it requires giving up something to get something.  We think of it as the Liquidity Trilemma (Exhibit 1).

EXHIBIT 1: THE LIQUIDITY TRILEMMA: IT’S ALL ABOUT TRADEOFFS

As of 1/31/2021. GSAM. For Illustrative Purposes Only.

 

In an ideal world, investors want their cash and cash alternatives (i.e., money market funds) to provide stability, liquidity and yield. In practice, it is virtually impossible to have an investment that does all three—especially in today’s yield environment. As a result, we think investors should identify which of the three they want to prioritize and assess the tradeoffs accordingly. 

 

Liquidity, Stability or Yield?

Investors who prioritize stability (a stable net asset value or NAV) while maintaining same-day liquidity might consider a government money market fund. But here’s one of the downsides: it may offer limited yield today.

Instead, we think investors with longer time horizons may consider ultrashort and short-duration bond strategies. In exchange for giving up the stability they would get with money market funds, investors may get higher income potential with reasonable liquidity. And we think strategies that focus on opportunities across the broad fixed-income universe may help reduce portfolio volatility.

Investors who want intraday liquidity may consider accessing this sector via an exchange-traded fund (ETF). We think investors who value direct ownership of securities over portfolio liquidity may consider a separately managed account.

We also think it’s important to point out that yield doesn’t often pair with stability or liquidity. But we think investors who are willing to assume some extra risk may want to consider adding exposure to lower-credit quality securities and extending duration. These strategies tend to have a longer time horizon and a sharper focus on yield and may provide incremental returns.

Still, we believe that investors should be mindful of not reaching too far for yield, as this can require steep liquidity and stability tradeoffs. After all, different sectors of the market have varying degrees of credit and liquidity risk, and therefore will behave differently during periods of market stress.

 

Short Duration Bonds: A Multi-Sector Approach

Finally, we believe it is important to note that not all ultrashort and short duration strategies are the same. The convergence of longer duration, low yields, and tighter spreads may create vulnerabilities for single sector strategies. Taking a multi-sector approach at the front end of the curve could make sense given the benefits of diversification and the fact that no one sector leads all the time.

While interest rates look likely to stay low, we think there is potential for a modest uptick this year. A new administration in the US, the winding down of Federal Reserve liquidity programs and changes to Treasury issuance all have the potential to create uncertainty and some interest-rate volatility.  That’s why we think it’s important to weigh the tradeoffs associated with short duration strategies.

 

1 Source: Morningstar. As of 12/31/2020.
2 Source: iMoneynet. As of 12/31/2020.

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