With the Fed Raising Rates, Short Duration Deemed Safer for Fixed Income

 | Jun 28, 2017 | 8:00 AM EDT
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The Federal Reserve has been on a slow but steady monetary tightening path. Besides raising interest rates, it has published detailed plans about how it will reduce its balance sheet, and speeches by various Fed members have been anything but dovish lately.

The Fed signaled three rate increases this year -- of which it already has done two -- and another three next year, besides the balance sheet reduction.

In this environment, the front end of the yield curve is attractive as a place to be right now for fixed-income investors, according to Eric Souza, a senior portfolio manager for SVB Asset Management.

"We're defensive on duration ... You can be defensive on duration in one of two ways: You can either build up cash, or you can buy short-term bonds. We prefer buying short-term bonds. With the flat yield curve, we like bonds in the front end," Souza told Real Money in an interview.

"We like that reinvestment opportunity. We can buy short-term bonds and, if the Fed raises rates, as these bonds mature we can re-invest them into higher-yielding securities."

Within the investment-grade fixed-income universe, Souza has a slight preference for corporate bonds and commercial paper, because historically in a rising rate environment these securities' spreads tend to tighten.

In the Treasury bonds universe, he noted that a three-month Treasury bill yields around 1% while a six-month bill yields 1.13%. "But then after that ... it's a very flat yield curve. For example, to go from 18-months Treasury to a two-year Treasury is a 'whopping' four basis points. That just doesn't make sense."

Some pundits worry that the flat yield curve announces an approaching recession. (Check out Doug Kass' Diary over at our sister site Real Money Pro for a comprehensive analysis of why that may be the case. If you are not a subscriber of Real Money Pro, click here to learn more about this service).

The spread between yields on two-year bonds and those on 30-year Treasuries hit a 10-year low recently. Some analysts say this has been a good indicator of a downturn in the past, but Souza does not believe a recession is on the cards for now.

"The economy is not hot, is not cold, it's right in the middle," he said, noting that the economic data have both positives and negatives. For example, the jobs report shows that wage increases are lower than before the financial crisis, but the jobs market has added around 17 million jobs since then.

"I think we'll still be stuck in a low 2% GDP growth period for a while," Souza said.

Corporate America is "sitting on the sidelines" because companies are still waiting for a lot of the announced reforms to be implemented.

"Companies don't know what their taxes will be, what their healthcare costs will be. That's affecting their hiring decisions, and also business and capital investment," he said.

While Souza does not believe the pro-growth reforms that President Donald Trump promised will be passed this year, he said the administration probably will implement the programs eventually, even if in slightly different forms.

"It's a new administration, it's still trying to find its way," he said.

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