While the magnitude of the rise in rates is not particularly surprising, one of the most interesting elements of previous tightening cycles is shown in the bottom table. In the previous three tightening cycles, the 2-Year Treasury Index posted positive returns solely due to the level of income cushion.3 Price returns were remarkably similar over these previous tightening cycles, despite their differing lengths of time. However, the key takeaway is that income returns allowed investors to avoid negative total returns. Given that this cushion has largely been diminished in the current environment, we believe it is unlikely investors will be able to avoid losses in short duration fixed income strategies if the Fed is earlier or more aggressive than the market anticipates.
As we illustrate in the chart below, investors should keep in mind that 2012 and 2013 were the two worst performing years for the 2-Year Treasury dating back to 1981.4 In 2012 and 2013, price returns contributed 4 bp and 8 bp to the overall return. The annual price returns for 2004, 2009 and 2014 were
-5.315%, -3.34% and -1.46%, respectively. The corresponding income returns were 5.57%, 5.34% and 2.09%. What will performance look like if the Fed surprises the market? How will investors react to potential negative returns in their short maturity bond funds?
While we believe that reducing interest rate risk in front of a change in Fed policy is prudent, focusing singularly on the short end of the yield curve may leave investors disappointed. In our view, a more prudent approach may be to hedge interest rate risk via zero and negative duration fixed income strategies as opposed to simply shifting to the short end of the curve.
1Source: Barclays, as of 12/31/1994 and 2/28/2015, respectively.
2Source: Bloomberg, as of 2/28/15.
3Source: Barclays.
4The inception of the 2- Year U.S. Treasury Bellwether Index. Source: Barclays, as of 2/28/15.
Important Risks Related to this Article
Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. In addition, when interest rates fall, income may decline. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.