Stagflation or soft landing: short duration is preferable
The good news for income-seeking investors is that the bond market currently offers good income opportunities.
Duration is cheap at the front end of the yield curve. Two-year U.S. Treasuries offer more than 90 basis points over 10-year U.S. Treasuries. Moreover, short-term yields are the first to drop in the event of interest rate cuts. The bias for shorter maturities is clear. However, in the case of stagflation, the long part of the yield curve might drop sharply, bringing plenty of upside to bonds with long duration. Yet the risk of holding such bonds is high, especially now that the future is uncertain.
Holding short-term bonds has its risks too. If you are holding short-duration bonds as a stagflation scenario develops, there is the risk that central banks might continue to hike rates and the value of your short-term bonds falls. That would be fine if you hold the bond until maturity and you are content with the yield you have locked in, yet you would suffer from opportunity risk. For example, you might be locked in a bond at a 4.5% yield for two years, but rates go to 6% in that timeframe. Yet, you will get your capital back at maturity, and you could ultimately reinvest at higher yields.
Income opportunities are even more striking in the corporate space. On average, investment grade U.S. corporates with maturity between two and five years offer 364 basis points over U.S. Treasuries. In comparison, U.S. investment grade corporates with maturity above thirty years offer only 300 basis points over U.S. Treasuries. In the U.S. high-yield space, corporate bonds with a maturity between two and five years offer almost 540 basis points over U.S. Treasuries, while junk bonds with a maturity between ten to thirty years offer only 450 basis points.
In Europe, investment-grade corporations with two to five years of maturity offer 127 basis points over German sovereigns. High-grade corporates with maturity between ten and thirty years offer 131 bps over Bunds, only 4 basis points over shorter maturities. In the European high-yield corporate bonds, those with a maturity of up to two years offer 550 basis points over German sovereigns, while those with a maturity between five to ten years offer only 474 basis points on average.
Reducing interest rate risk while maximizing returns is critical in an evolving macroeconomic environment. That's why short-term securities offer an ideal risk-reward trade-off.
What instruments can I consider to get exposure to short-term bonds?In the case of U.S. Treasuries, European Government bonds, and U.S. and European corporate bonds, you can trade the cash instrument by searching for bonds in the Saxo platform screener.