Last year’s blistering pace of interest rate hikes was a serious weight on fixed income, with bonds across the board enduring some of their worst returns on record. Of course, those freshly invigorated rates set the table for generous yields this year, with many areas of the market poised for their strongest results in more than a decade.

Short-term bonds, which mature in the next few years or sooner, are at the center of this dynamic. Their yields rose dramatically in the first half of 2023 as the Federal Reserve hoisted interest rates to combat inflation. One popular short-term bond index, for example, recently touched a 15-year high. Because of their higher turnover, short-term securities tend to track movements in the federal funds rate, meaning that yields on new securities could climb further if the central bank keeps pushing up rates.

Beyond that, short-term bonds appear to be well positioned should volatility hit. In general, these bonds have a lower “duration” — or sensitivity to rate hikes — than do long-term securities. That means short-term bonds could feel less of a sting if inflation remains a problem and the Fed boosts rates more than expected. On the flip side, short-term starting yields are high enough that they’ll likely offer attractive returns relative to longer term offerings even if rates fall from here.

“Short-term bonds are really interesting, as you’re getting a higher yield right now, and you’re also a little more protected amid the volatility,” explains John Queen, a fixed income portfolio manager at Capital Group Private Client Services.

Rates are a major question mark.

Like the outlook for the economy and the path of interest rates themselves, the direction of short-term yields is hazy. On the one hand, the economy continues to impress, but inflation remains a concern. The consumer price index rose 3% in June from a year earlier, above the Fed’s target rate of 2%. The combination of jaunty growth and elevated inflation normally suggests more rate hikes to come.

Then again, other factors point to softer growth and the possibility that the hiking cycle is nearly complete. These include the collapse of several midsize U.S. banks, which could crimp lending activity; renewed economic weakness in China, which could suppress global growth; and the delayed impact of the Fed’s double-digit rate hikes, which could impinge on U.S. consumer spending.

“Reports keep coming out that support one camp or the other, and we're seeing significant volatility,” Queen says.

Recently, the Fed lent some credence to the “end cycle” proponents when it held rates steady in June — the first time in 10 meetings that it hadn’t raised rates. However, that may have been a temporary respite if inflation festers.

“If inflation remains stickier than expected and the economy holds up, then we may be in for higher rates than the market’s currently pricing in,” Queen adds. “My view is that rates will stay higher longer than market consensus.”

A yield curve inversion could provide opportunities in portfolio positioning.

Treasuries are experiencing a phenomenon called a yield curve inversion, which is a commonly cited sign of impending recession. In typical markets, bonds with longer maturities offer more yield, reflecting the higher compensation that investors demand for locking up their money for extended periods. Today, however, two-year notes yield more than 10-year notes. Such inversions haven’t always presaged recessions, but every economic contraction since 1955 has been preceded by an inversion. The current inversion began in late 2022, but briefer inversions happened as early as March of last year.                 

Queen believes the yield curve will steepen — that is, it will move toward a more typical shape in which short-term yields are lower than long-term yields. That could happen as shorter yields shrink, longer yields grow or both. Queen is pursuing a two-pronged “steepener” strategy that involves increasing exposure to shorter term Treasuries in the belief that their yields will decline and their value will rise. This is paired with lower exposure to longer term Treasuries, with the expectation that those yields will drift higher.

Market conditions are still uncertain, encouraging defensiveness.

Across fixed income, the foggy economic outlook makes it ever more important to select bonds with strong creditworthiness.

“We’re still cautious on the outlook for credit over the next six to 12 months,” says Vince Gonzales, a Capital Group fixed income portfolio manager. “We think there’s potential for continued volatility, as the economy faces headwinds and a possible slide into recession. It highlights the importance of focusing on sectors that have been resilient and avoiding areas that have deteriorating credit profiles.”

Gonzales is finding opportunity in securitized debt, especially in the residential mortgage-backed securities and commercial mortgage-backed securities markets, both of which have underperformed the broad market this year. He also sees value in high-quality consumer-oriented areas such as auto asset-backed securities, and areas with resilient cash flow, such as securities linked to mobile phone contracts.

“Everyone’s talking about how attractive money market funds are, but you’re able to buy very high-quality securities — not just from a rating standpoint but from an underlying credit structure standpoint — at yields that are about 1.5 to 2 percentage points in excess of what money market funds currently offer,” Gonzales says. “I think it really highlights the value proposition of targeting an attractive yield on a very high-quality short-duration portfolio.”

Whether it’s the path of interest rates, a potential recession or geopolitical risks, investors are parsing numerous variables in determining their next moves.

“As we think about all the uncertainties, it makes sense to remind ourselves of why we buy bonds in the first place,” Queen says. “We own bonds as part of a broader portfolio, aiming to basically smooth the ride and lower volatility.”