As Perceived Risks Rise, Limited-Term U.S. Government Funds Offer Shelter


August 29, 2017 [government bonds, credit risk, economic growth]
Charles Roth

Select short-term government bond funds offer minimal risk and some income as higher-risk assets get frothy and tail risks loom.

U.S. Treasury Department, Washington DC


Most U.S. risk asset prices have enjoyed a long ride higher amid slow-but-steady economic growth, scant inflation and still ample central bank monetary support. But if fund flows are any indication of where portfolio managers expect markets to go, recent data may be signaling a rotation into less pricey securities.

It makes sense to take some profit on things that may not have much upside left and either put them into others that do, or into far less correlated investments that aim principally to protect capital and provide a little income. More upside is clearly seen in flows to European and emerging market equities thanks to their accelerating economic growth and the still early stages in their current earnings cycles. For those concerned about potential crowding in this trade, or “tail risks” such as major central bank policy mistakes, skittish bond markets precipitously shifting into panic mode or geopolitical risks escalating sharply, a meaningful allocation to among the safest of havens, limited-term U.S. government bonds, makes sense.

According to BofA Merrill Lynch’s August 24, 2017 Flow Show report, U.S. equity funds suffered 10 consecutive weeks of outflows, the longest such streak since 2004. During the previous two months, investors pulled $30 billion from U.S. equity funds and put $36 billion into overseas equities. U.S. high yield bond funds also saw outflows in eight of the previous 10 weeks, while inflows into U.S. government funds, at roughly $900 million, were the biggest in 10 weeks. S&P Global, citing Lipper data, also reported that high yield fund redemptions, including exchange traded funds, hit $1 billion during the same weekly period, bringing outflows to $3.2 billion over the two weeks to August 23, 2017. Cash levels also appear to be going up.

“Yet cash at banks yields close to zero,” notes Thornburg’s Jeff Klingelhofer. That’s not the return mutual fund investors typically want for any extended period. Some investors may seek shelter in low duration bond and bank loan products, though both generally have elevated credit components, and in the case of the latter, usually limited or no call protections. Although faster U.S. Federal Reserve interest rate hikes isn’t currently a market concern, a slow grind higher in rates will no doubt at some point prompt more and more investors to seek safer, shorter duration products, especially now that rates at the front end of the yield curve are a little higher. In this regard, it’s also notable that even bank loan funds, which sport variable interest rates, have seen outflows of late, according to Lipper.

Actively managed, laddered portfolios that can reinvest proceeds from maturing issues at both the long end of their ladders and, opportunistically, along their staggered maturity segments based on fundamental risk/reward analysis, can provide an excellent place to park money for the short or long terms. Select funds in the category can also generate respectable income from a variety of sources—from well-structured government agency debt to collateralized mortgage obligations and mortgage pass-through vehicles to asset-backed securities.

To be sure, limited-term U.S. government bond funds shouldn’t be considered the equivalent of risk-free money market funds, as they will move with markets, though in more muted fashion relative to equities and other riskier assets. Still, they can meaningfully lower overall portfolio volatility.

Cognisance of prepayment terms across portfolio positions can help mitigate convexity, or the impact from interest rate shifts, at both the security and portfolio levels, Klingelhofer notes. When the inevitable bouts of market volatility set in, investors who have rebalanced a bit more into discriminating limited-term U.S. government bond funds should appreciate their negligible credit risk and low exhibited volatility. They should also like the income from highly safe securities offering attractive risk/reward propositions. Smoother portfolio performance is nicest when markets get bumpy.

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