As risks rise, the short end can offer yield and some shelter

Fixed income investors entered the year holding a few reasonable expectations on interest rates, spreads and returns. The conflict in the Middle East has upended these assumptions. How should investors respond?

The surge in energy prices has led to one of the sharpest selloffs in the core rates market since the Covid-19 pandemic. At the time of writing, yields on US Treasurys, bunds and gilts are 30–80 basis points (bps) higher than at the end of February, with markets now pricing in further rate hikes across both developed and emerging economies.

The pace and scale of these moves have briefly pushed most fixed income indices into negative total return territory. But there has been one notable exception: short duration.

Short duration credit – between one- and three-years – has provided higher running yields and limited interest rate sensitivity, which has kept returns positive.

Lingering uncertainties

Longer-dated debt might appear more appealing at first glance – the yield on the 30-year US Treasury was just under 5% on 23 June – but the outlook remains uncertain and the direction of inflation is unpredictable. 

In the US, the long end of the yield curve is likely to stay under pressure due to fiscal concerns and the possibility that the Federal Reserve could accelerate balance sheet reduction under new chair Kevin Warsh. In Europe, inflation and long-dated yields remain closely tied to energy dynamics. In the UK, political uncertainty is likely to keep gilt markets volatile.

Against this backdrop, we believe the one- to three-year segment of the curve stands out as particularly attractive. In US Treasurys, investors can lock in yields above 4% with a duration of roughly 20 months. Even if yields were to rise by a further 100bps, one-year total returns should remain attractive.

Extending maturities into the five- to seven-year range offers only around 15bps of additional yield in US Treasurys and 40bps in the Global Aggregate index, but at the cost of a significant increase in duration – by roughly four years. As a result, a comparable move in rates would likely erase annual returns entirely. In addition, spread duration rises materially, leaving portfolios more exposed to any further widening in credit spreads, especially if inflation proves more damaging to global growth.

With volatility likely to persist and macro risks still unresolved, prioritizing shorter-duration assets offers a potentially more resilient way to capture income while limiting downside exposure. Until there is greater clarity on inflation, policy direction and geopolitical developments, we believe the front end of the curve provides a compelling balance of return and risk that longer maturities currently struggle to match.

Read more about our current views on positioning at Fixed Income Perspectives