By Patturaja Murugaboopathy
(Reuters) - Short-term U.S. government bonds have attracted bigger investment flows this year than longer-term paper, an unusual pattern engendered by the inverted yield curve and the Federal Reserve's intent to keep interest rates higher for longer.
The Fed's aggressive rate hikes and hawkishness have kept short-end yields elevated for most of 2023. One-year Treasury note yields are about a percentage point higher than those on 10-year bonds.
That has meant global investors can avoid the relatively less liquid, longer-tenure bonds just for the sake of extra yield and premium.
According to Morningstar data, inflows into short and medium-term U.S. Treasury bond funds, which invest in maturity periods of 1 year to 6 years, stood at $29.3 billion in the first eight months of this year, a 70.3% rise over last year.
On the other hand, inflows into Treasury funds that invest in bonds with maturities longer than six years dropped to $36.9 billion, an 11.5% decline from last year.
"The absolute yield on short-term Treasuries is extremely attractive. Currently, 2-year Treasuries are yielding over 5%, a level that has not been present in almost 20 years," said Adam Coons, portfolio manager at Winthrop Capital Management.
"Additionally, the 2-year note is out-yielding the S&P 500 by over 3.5%, which is also the highest difference in 20 years."
At its latest policy review, the Federal Reserve reinforced the hawkishness and, besides keeping the door open to more rate rises, it has kept rate projections through 2024 significantly higher than previously expected.
LSEG Lipper data shows U.S. short-term bond funds have outperformed this year, delivering a gain of 2.2% in price terms compared with an average 2.1% dip in long-term bond funds.
Among top short-term funds, the iShares 0-3 Month Treasury Bond ETF has drawn about $7.3 billion in inflows this year, while SPDR Bloomberg 1-3 Month T-Bill ETF, and WisdomTree Floating Rate Treasury Fund have attracted a net $2.1 billion and $4.4 billion respectively. The cumulative flows of the three funds were 13.4% higher than last year.
PICKING MATURITIES
Long-term bonds have their defenders.
"The key reasons to own a long-dated bond is to lock in current interest rates and protect against lower rates in the future, and owning a long-term bond can be viewed as protection against a softer economy where yields may drop, and thus prices rise," said Matt Dmytryszyn, chief investment officer at Telemus.
Most analysts expect short-term bond funds to continue to lure more money in the months ahead.
"I continue to discount the belief that it might be appropriate to cut rates soon. I don’t think we get to that point without a recession," said Jeff Klingelhofer, co-head of investments at Thornburg Investment Management.
Klingelhofer reckons a 3.5-year is the sweet spot, since even in a deep recession, longer-end rates would not fall much "because we have exited the world of very low, sustained rates."
To reduce the risks of a possible Fed easing in case the economy decelerates, Winthrop's Coons said he is using the inverted yield curve to run a barbell duration strategy.
"We are anchoring portfolios with the higher yielding short-term bonds. We are then reducing or eliminating exposure to bonds with maturities 3-9 years and instead investing into duration through 10-30 year bonds," he said.
"The longer-duration bonds will have a higher sensitivity to the movement in interest rates, giving us more appreciation potential over the intermediate to long term."