Short-Term Yields Won’t Last Forever

After more than a decade of yields sitting well below historical averages and often close to zero for shorter maturities, treasuries have been relatively unattractive investments for quite a while. Recently, however, the market environment for all fixed income has changed dramatically as yields rose to their highest levels since 2007. Investors rotated into short-term treasuries—those maturing in under three years—with astounding alacrity and short-term treasury ladders surged in popularity. Although purchasing shorter-term treasuries may seem like a “safer” approach, as with any investment, there are inherent risks. Here, one of the most significant is reinvestment risk.

In 2022 alone, short-term treasuries and short duration Exchange Traded Funds (ETFs) saw record inflows of over $70B for the year. In comparison, the same group of ETFs have seen approximately $8B of outflows so far this year. How can we explain this? As indicated by the chart below, we are currently experiencing the most inverted yield curve since the 1980s, which is usually a signal that the market expects rates to be lower in the future. That said, investors appear to be shifting the duration of their investments rather than fleeing the asset class entirely..

With longer tenors also comfortably outpacing inflation, intermediate duration (3-10Y) ETF strategies have seen consistent inflows totaling over $49B over the course of the past 12 months. These observations lead us to believe that the market is anticipating a future normalization of the yield curve as the Federal Reserve halts or greatly slows the pace of rate increases; perhaps cutting them should the economy slide towards a recession.

Many investors, however, are still purchasing ultra short-term treasuries fully expecting their attractive yields to continue into the foreseeable future—often without realizing that the quoted yields are annualized while the security matures sooner than one year. The downside of purchasing such short-term treasuries is that it matures so quickly, and another investment must be found and purchased to replace it. In a rising interest rate environment, this flexibility can be advantageous; less so in a falling one. That is what financial professionals call reinvestment risk.

With indications of a peak in interest rates approaching, we would advise that clients lock in current rates, minimize reinvestment risk, and extend the duration of their fixed income portfolios by purchasing longer-term treasuries and quality investment-grade corporate bonds.

Authored by:
Arian Mirfakhraee – Portfolio Manager & Patrick Moran – VP of Corporate Strategy, Portfolio Manager

Manager Moran Wealth Management®

as of 8/29/2023

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