Fixed Income: No Compensation for Duration Risk

An analysis of forward yield curves shows that the market predicts a flattening yield curve in the future, as short-term interest rates rise while long-term rates fall. If this market prediction holds, short-term rates will be at a similar level to long-term rates. Investors generally expect to be paid a premium for holding longer-term bonds because their principal is tied up for longer, but with a flat yield curve, that premium is virtually zero. Thus, investors are not currently being compensated for taking duration risk. With interest rates near all-time lows (10-year Treasury interest rate sunk to a historical low of 1.37% in July of 2016), duration risk is currently relatively high.

In an environment where investors are not being compensated for holding bonds with extended maturities, we recommend that investors (1) allocate to short duration instruments and (2) maintain an overweight posture (vs. policy target) to floating rate securities (e.g., bank loans).

Abroad, bond purchases by the European Central Bank and Bank of Japan continue to distort fixed income markets, creating artificially high prices and low yields. These yields, at or near historical lows, fail to compensate investors for substantial interest rate risk. Thus, we recommend an underweight position in global fixed income.