Higher Short-Term Rates Offer Investors More Protection
Updated: Oct 23, 2018
Investors have waited a decade for higher short-term yields. Higher yield levels now offer more protection to investors that are concerned with rising rates.
HIGHER INCOME POTENTIAL
The yield on the 2-year AAA municipal bond has risen from under 30 basis points in 2014 to over 160 basis points today. For a high-net worth resident in Colorado, that equates to tax-equivalent yields approaching 3.0%. Investors willing to take additional credit risk might consider the BBB sector that yields an extra 30 basis points.
LOWER INTEREST RATE RISK
As seen in the chart below, 2 Year AAA Municipal Yields have started climbing from an all time low of 0.24% in 2014 to a recent high of 1.86% in 2018. At current yield levels, a short-term bond can handle a 150-basis point rise in yields and still produce a positive return over one year. This is due to the bonds short maturity and rapidly decreasing duration.
WHY CONSIDER LOWER QUALITY SHORT TERM BONDS?
Issuers will often provide bond investors extra protection in the form of reserve funds and higher liquidity ratios. Some metro districts and charter schools, for example, have reserve funds equal to one year’s worth of debt service. From a credit quality perspective, these liquidity metrics may provide added comfort when purchasing 2-year and 3-year bonds in lower or non-rated sectors.
1. This assumes a 2-Year 2% Coupon Bond with a YTM of 1.64% that is repriced after one year at 3.14% for a total return of 0.19%. This does not include reinvestment income, management fees or other trading related expenses. Data for chart retrieved 8.10.2018 from Bloomberg. Past performance is not indicative of future results. Purchasing bonds includes the risk of loss of principal. This is not a recommendation to buy or sell a specific security.