Why Intermediate Bonds? Maximizing Risk-Adjusted Yield

Bond Concepts by Madison Investments

With interest rates across the yield curve luring investors away from cash and short-term bonds, we think it prudent for advisors and investors to consider the risk and return tradeoff in their fixed income allocation and ensure they are being adequately paid for risks being taken, should they move out the maturity spectrum. While some investors may choose to lock in rates through the purchase of longer maturity, individual bonds, many will look to a diversified, separately managed account, mutual fund, or ETF solution. In doing so, it is easy to revert to the tendency to simply assume that broad market strategies with longer durations will deliver greater yield and total return potential than intermediate-term strategies. However, when you examine current valuations and historical performance patterns, the data tells a different story, particularly on a risk adjusted basis.

Yield per Unit of Duration Favors Intermediate Bonds

Yield per unit of duration is one metric that can help investors compare and value bonds with different maturities. Think of it as return potential per unit of interest rate risk, not unlike a Sharpe or Information Ratio often used in the equity markets. For our analysis, we compared the Bloomberg Intermediate Government Credit Index, comprised of bonds maturing in 1 to 10 years, to the longer-duration Bloomberg Aggregate Bond Index, which contains bonds with maturities ranging from 1 to 30 years.

Currently, the Aggregate Index yields 4.22% with a duration of 6.09. Its yield per unit of duration of 0.69 is well below its historical average. The Intermediate Government/Credit Bond Index currently yields 3.92% with a duration of 3.74. Its yield per unit of duration of 1.04 is slightly above its historical average. Based on this, we would argue that, on an interest rate risk-adjusted basis, a portfolio of intermediate bonds represents fair value, while longer, aggregate portfolios are quite rich.

Little Absolute Spread Advantage in Longer-term Bonds

It seems logical that the absolute reward for taking additional risk should impact the decision on how much risk to take. As the charts below show, for most of the past quarter century, the average yield reward for moving from an intermediate to a broad market strategy has traditionally been a bit over one-half percent (0.5%) and is often double that. Today, that difference is near historically low levels. This prompts a fundamental question: why accept more risk for seemingly comparable yields?

Contributing Factors – Spread Risks: Credit, Structure, and Liquidity Risk

A contributing factor to our thesis above is the role risks other than interest rate risk play in explaining relative performance between intermediate and longer-term bond portfolios in various market environments. The total risk of a portfolio is a function of not only interest rate risk, often measured by duration, but also what is called spread risk, which is made up of credit, structure, and liquidity risk.

While the Aggregate Bond Index has 63% more duration (interest rate) risk than the Intermediate Index (6.09 vs 3.74 duration), the additional exposure to spread risk is just as dramatic. In bonds, spread risk is not simply a function of how much of something you own but also the average maturity or duration of that exposure. The longer the maturity and duration, the more you are exposed to changes in spreads.

The table shows the exposure to each of the spread sectors as a percentage of the total benchmark and the average duration of each exposure.

Not only does the Aggregate Bond Index have more exposure to the spread sectors (51.21% vs. 29.88%), primarily due to the introduction of the mortgage markets (this is where the structure or prepayment risk comes in), but the duration of those exposures is much longer (6.32 vs. 4.10).

Why does this matter? Generally, interest rate and spread risk are relatively uncorrelated. If the economy is doing well, spread risk is being rewarded as spreads on risk assets shrink, but rates tend to be increasing. Conversely, when the economy is doing poorly, spreads widen, but rates fall. This helps explain why an intermediate portfolio, with much lower exposures to both interest rate and spread risk, can be a good, less volatile alternative to a longer maturity structure, especially when the additional yield available on risk assets is near historically tight levels.

Fed Easing and the Myth of Parallel Shifts

Investors should also consider the monetary policy environment and the potential for cuts to the Fed Funds rate. During periods of easing monetary policy, conventional wisdom would suggest that long-term (10-year and longer) bonds with greater sensitivity to interest rate movements would benefit the most from falling yields. However, duration does not contribute to performance in these periods as some may expect, as bonds with maturities in the intermediate range have historically performed in line with or better than bonds with longer durations.

The main reason for this is that interest rates across the curve rarely move down in parallel. Yields in the 1-5 year range tend to be more impacted by the Fed. During a Fed easing cycle, short to intermediate rates often fall more than longer-term rates, steepening the yield curve. To illustrate, we charted the returns of the aggregate and intermediate bond indices beginning two months before the first Fed Funds rate cut and ending two months after the final cut for each of the Fed’s last five easing cycles. Take out the unprecedented circumstances of COVID and, whether due to the non-parallel steepening of the yield curve or exposure to spread risks (likely both), intermediate portfolios have outperformed expectations, performing in line with or better than a portfolio of broad market bonds.

Conclusion

The return of yield has presented investors with one of the better opportunities of the past 20 years to invest in fixed income. Given the risk dynamics within the bond market and historical yield curve trends, we argue that the intermediate maturity portion of the bond market offers a superior risk/reward profile compared with longer maturity alternatives.

This is not to say that longer, aggregate-like portfolios are an inappropriate investment for everyone. Many investors want or need that longer duration exposure—think of life insurance companies, pension plans, or investors with very long investment horizons. Some retail investors may see a higher yield for a longer maturity bond versus an intermediate bond and decide to buy and hold to lock in that rate for a long period of time. However, for many investors looking for traditional exposure to the domestic bond markets, we believe now is a good time to invest, and intermediate-maturity bonds have the greatest risk-adjusted, total return potential.