In music, two voices raised in harmony can be sublime. In investing, two factors working in harmony can drive results and structural total returns.

However, many investors observing bond markets in the first quarter of 2022 found themselves questioning the traditional “duet” of capital appreciation plus carry/income to produce total returns. Negative total returns in short-term bonds – along with uncertainty producing volatility in typically stable short-term rates indices (see Figure 1) – have been a dissonant experience.

In our view as active practitioners in short-term markets, the duet construct remains in place, although the rate volatility we’re witnessing has not always been accompanied by generally higher spot yields – as of yet. Nonetheless, elevated forward rates are a signal that in time, carry is likely coming and market conditions today may present investors with defensive allocations with structural ways to earn more income from their capital. (Carry in this sense is the potential income, or yield, on a bond portfolio over time from various sources.)

Front-end fixed income offers a balanced approach

The current environment provides an opportunity for cash investors to step out from traditional savings vehicles, which so far have lagged this increase in yield, in order to earn higher income going forward. The recent recalibration in front-end U.S. yields provides investors with attractive carry and income options given the market’s recent expectations of Fed hikes priced into the yield curve. For context, owning a 2-year note at about 2.50% not only implies that you can earn that yield for two consecutive years (absent any opportunities to repo the note out at special/negative yields and earn more income), but that the breakeven 1-year yield in one year is an astounding 3.3%. Thus, if the 1-year yield is at 3.3% in one year, forward rates are realized and you wouldn’t lose money, and if the 1-year yield is lower than 3.3% you would have made money from duration. The hurdle rate to lose money from duration is relatively high now. Current yields, and specifically forward-implied yields on high quality fixed income allocations with average maturities of approximately two years or less may offer an attractive venue for investors looking for income, without incurring significant interest rate exposure.

As such, the front-end looks remarkably fairly priced.

Not all near-cash investments present similar opportunities: Two differentiating themes limit traditional approaches to cash management

The lack of harmony in short-term fixed income markets this year has a range of underlying factors, consolidating these diverse factors into two themes to keep top of mind:

Lack of yield at the very front-end will continue:

• Bank deposit yields languish. Given rampant excess reserves, banks have no need to pay market rates to attract funding. In fact, particularly with institutional deposits, banks would happily look to push these excess reserves into money market funds or other cash alternatives and encourage this by keeping deposit rates low. We assume deposit rates are unlikely to increase much in the next year given the aggregate level of excess reserves remaining in the system.
• U.S. Treasury bills, especially short-dated ones, are trading relatively low in yield versus the Federal Open Market Committee’s benchmark rates. In other words, we see them as rich. While T-bills offer the stability of high quality, this is expensive on two fronts: 1) T-bills maturing six weeks and shorter have been trading at yields less than the Fed’s yield on its reverse repo facility of 0.30%, and 2) on a relative basis, T-bill yields are trading at the tightest level to overnight indexed swaps (OIS) in more than 15 years as demand outstrips supply. Also, seasonal tax receipts tend to drive seasonal reductions in T-bill supply. At the same time, the Fed seems to be opting against offsetting some of this supply gap as it only gradually (rather than aggressively) unwinds its roughly $300 billion T-bill portfolio, favoring runoff only when the amount of maturing coupons fails to reach its cap.
• Money market strategies have tended to lag Fed rate hikes. Similar to the 2015 Fed tightening cycle, money market strategies will likely lag policy rate increases by 50 basis points (bps) or more in the coming months due to the combination of ultra-passive approaches to embracing rate hikes as well as reclaiming-fee considerations which have been previously waived by managers during the lower-rate environment.
• Repo rates (to invest cash) remain low. Over the past few weeks, overnight repo (SOFR, the Secured Overnight Financing Rate) has tended to trade at yields lower than the Fed target for the interest rate on excess reserves (IOER) currently at 0.30%. We see this as evidence of cash that is seeking safety even at uneconomic yields. Money market investors and managers appear to be paying to avoid risk by opting for the least duration.

Remain vigilant to changing costs for liquidity

Changing market liquidity is a growing concern, with increasing costs for transactions requiring investor awareness of costs to reallocate risk and potentially necessitate longer holding periods:

• Excess reserves are looking for a home, but liquidity costs and conditions remain challenging. The increase in the Fed’s use of reverse repos, or RRP, removes liquidity and reserves from the system. Its usage remains elevated at near-record levels of $1.7 trillion as its yield outperforms most short-term non-credit assets.
• Transaction costs have increased. So too has the relative cost of capital to deploy. Investors may have longer holding periods in this more volatile, higher-rate environment to come.

We believe that harmony in short-term markets comes from the opportunities to have an accompaniment of carry in the months ahead along with capital appreciation to produce total return for cash and short-term investors.

Many of these factors will remain considerations for defensive investors in the coming quarters. Amid risk and volatility, however, potential income from bonds may begin to play a more soothing melody. While we are some months away from the Fed’s balance sheet runoff having a significant effect on the sheer size of excess reserves in the system, these costs of being too defensive may weigh heavily on investors, who in turn may consider moving beyond the confines of traditional liquidity management.