Short-dated credit: income without the rate call

Take oil.

The Financial Times recently noted that the correlation between oil prices and the US 10-year Treasury yield had risen to 65%, close to levels last seen around the first Gulf War in 1990.¹ This relationship highlights how closely the rates outlook has become tied to developments in energy markets. But oil is notoriously difficult to predict, relying on calls on geopolitics, inflation and central-bank reactions. A difficult task for even the most seasoned market participants.

For us, the more practical question is whether uncertainty over rates should stop investors allocating to fixed income altogether. We believe the answer is no. Indeed, periods like now can create particularly compelling opportunities in short-dated credit.

This is not 2022

Investors' last experience of rising rates may still be influencing decision-making today. The rapid move from negative interest rates to 4% during 2022-23 created one of the most challenging periods for fixed income investors in decades.

While some of the catalysts behind today's inflation concerns may feel familiar, including supply-side disruptions and higher energy prices, the backdrop is very different. The European Central Bank deposit rate already stands at 2.5%, meaning central banks are starting from a structurally higher level than they were in 2021.

As a result, we believe any further tightening is likely to be considerably more limited than the hiking cycle investors experienced in 2022-23. This is not a journey from negative rates to 4%. Rates are already much closer to levels that would historically be considered restrictive.

Markets have also moved quickly to reflect this risk. Forward markets are already pricing the euro cash rate close to 3.5% in one year's time, suggesting investors have largely adjusted to the prospect of further tightening.

So, while holding cash can appear attractive during a hiking cycle, bond markets don’t wait for rate hikes to occur before repricing. Much of the adjustment in yields takes place as expectations change, often well before central banks act.

With bond markets having already repriced significantly, investors today are being compensated for much of the uncertainty surrounding the path of interest rates.

And, even if rates rise somewhat further, short-dated credit remains resilient. Breakeven yields on one-to-three-year credit are close to decade highs, meaning yields would need to rise by more than 2.5% before investors experienced a negative return over a 12-month period.

Higher yields have created a rare opportunity

The yield on one-to-three-year euro credit currently stands at approximately 3.8%. Over the past decade, yields have been above 3.25% in only around 25% of monthly observations, making today's yield opportunity relatively rare by recent standards.

History suggests these periods have often proved attractive entry points. Following instances when yields exceeded 3.25%, subsequent annualised returns averaged 5.0%, 4.7% and 4.6% over the following 12, 24 and 36 months respectively.

In other words, investors earned more than the starting yield as income compounded and interest-rate cycles stabilised.

The experience relative to cash is equally compelling in our view. When starting yields exceeded 3.25%, short-dated credit outperformed cash in 73% of subsequent 12-month periods, rising to 82% over 24 months and 97% over 36 months.

The magnitude of outperformance was also meaningful, averaging between 1.6% and 1.8% per annum. In short: investors remaining in cash while waiting for a clearer signal on rates may be missing the opportunity reflected in current higher yields. ²

Final thoughts…

Our point is not that rates cannot rise further. Nor is it that geopolitical risks no longer matter. Rather, today's starting point is fundamentally different from that of 2022. Markets have already repriced materially, yields are significantly higher and investors are being compensated for a considerable amount of uncertainty.

For those seeking income, that means the case for short-dated credit does not depend on making a perfect call on oil prices, central-bank decisions or the path of interest rates. Aberdeen’s Short Dated Enhanced Income Strategy seeks to capture this opportunity, while limiting investors’ sensitivity to further changes in interest rates.