Impact Blog
Short duration a bright spot on volatile horizon

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Calvert disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Calvert are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Calvert fund. References to individual companies for Engagement or Research purposes are provided for illustrative purposes only and may not be representative of the results of all of Calvert’s engagement efforts. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Vishal Khanduja, CFA, Calvert Fixed Income Portfolio Manager and Brian S. Ellis, CFA, Calvert Fixed Income Portfolio Manager

      Boston -- In the fixed-income markets, short duration has been one of the few bright spots in a year of challenging investment returns, gaining 0.86% year-to-date, as measured by the Bloomberg Barclays 1-3 Year U.S. Credit Index, versus -1.79% for the broad Bloomberg Barclays U.S. Aggregate Bond Index. Despite prospects for a continued rise in interest rates, and the likelihood of ongoing volatility, we believe risk-adjusted returns in this segment of the bond market are poised to stand out again in 2019. In our view, the best way to evaluate and capture opportunities in this environment is through a multisector, diversified approach with robust credit analysis.

      Calvert blog 12-21-18a

      Challenge means opportunity

      To be sure, short-duration investors had to weather challenges of their own in 2018. The Federal Reserve continued to tighten policy by delivering four additional rate hikes. It also continued to reduce its balance sheet. While the resulting increase in Treasury supply was expected, the more meaningful increases in net supply resulted from changes in fiscal policy. The 2017 tax-reform bill resulted in a large increase in deficit spending, a significant portion of which was funded by Treasury bill issuance. The tax bill also enabled corporations to repatriate large amounts of their cash, much of which was invested in short-term, fixed-income securities. This selling pressure from the liquidation of offshore, corporate-cash portfolios was meaningful and contributed to wider credit spreads.

      Yet, these challenges are also reasons why short duration may be set up for strong performance in 2019. First, higher starting yields enable a much larger cushion against higher interest rates. For example, the two-year Treasury note yield can more than double from today's levels and still produce a positive total return over one year. This measure of risk-adjusted carry on the short end is the most attractive it's been since the financial crisis.1 Second, supply technicals should be more balanced as Treasury bill issuance remains high, but corporate cash-related selling fades. Third, wider credit spreads provide an additional cushion against higher rates and are more attractive after recent widening.

      Calvert Blog 12-21-18b

      A selective approach required

      We expect global growth to slow somewhat, but to remain strong, particularly in the U.S. This should support corporate earnings growth and keep default rates low. After widening throughout 2018, credit spreads have become more attractive broadly, but especially at the front end of the yield curve. This is particularly true considering yield curves continue to be relatively flat. It is prudent, however, to take a very selective approach to corporate credit at this point in the cycle. From an asset allocation standpoint, we prefer exposure to financials over nonfinancials. Even in the face of continued media stories about the volatility in credit ratings, U.S. money center banks, for example, have ratings on an upgrade trajectory. In nonfinancials, we believe investors should become increasingly selective, as concerns over leverage and potential ratings downgrades will continue into 2019. However, attractive opportunities exist in credit issuers with strong fundamentals and reasonable leverage, or those with clear and credible paths to deleveraging.

      From a tactical standpoint, recent spread widening has offered opportunities in short-maturity, investment-grade floating-rate securities. While a less hawkish path of rate hikes could marginally weigh on demand, we believe the recent credit market sell-off has been overdone. There are specific opportunities where spreads in floating-rate securities are significantly wider than for their fixed-rate counterparts. This dislocation has created opportunity. In addition, the recent spread widening has pushed the prices of several callable securities below par. This has created attractive risk-return profiles in those securities where a call is reasonably likely, such as in the banking sector and those with deleveraging objectives.

      Consumer strength to continue

      There has been remarkable improvement in the balance sheet of the U.S. consumer since the financial crisis. While the pace of improvement has been slowing, continued gains in employment and wage trends should provide further support. Additionally, at least in the short run, lower oil prices should provide an additional tail wind.

      This strength should translate into continued, strong credit performance in consumer and residential housing-related asset-backed securities (ABS). Similar to 2018, structural features such as seniority and principal amortization, which combines both interest and principal payments from an ABS security, should contribute to solid returns with low volatility.

      Active management makes sense

      In 2018, the dispersion of fixed-income returns shows that diversification can provide significant advantages. With volatility likely ongoing, this approach should continue to benefit fixed-income investors in 2019. An active and flexible approach, with the ability to allocate across multiple sectors, should allow investors to capture the best risk-reward opportunities.

      Bottom line: Although volatility may be darkening the investment horizon, short-duration assets appear poised to shine again in 2019. Selectivity and active management are key to uncovering opportunities and securities with the most attractive risk-reward profiles.