After a historically poor year for the bond market in 2022, investors came into this year looking to avoid another big drawdown. Understandably, the desire to preserve capital combined with the highest short-term yields in over two decades motivated investors to flock into short duration investments, particularly T-bills and money market funds. While we understand the sentiment and see the value for a portion of a portfolio, we think now is a good time to examine the proposition more closely. Like many things in life, when something seems too good to be true, it usually is.
Thanks to elevated short-term rates, the year-to-date return for the Bloomberg U.S. Treasury Bill 1-3 Months Index through April 30 was 1.5% (4.6%, annualized). That was a solid return, particularly for such short-dated securities, but it was significantly below the year-to-date return for the Bloomberg U.S. Aggregate Bond Index (the Agg) over that same stretch, which was 3.6% (11.4%, annualized). The Agg’s outperformance was due to capital appreciation from falling yields at the long end of the curve, which of course did not benefit T-bills as they have nearly zero duration. In fact, as we discuss below, falling short-term rates have essentially the opposite effect on short duration bonds.
Reinvestment Risk is the Primary Challenge
One of the key objectives of a fixed income allocation is to prepare for specific future funding needs: providing a pension for employees, building a factory, saving for retirement/education, etc. Given that most investors have multi-year (or multi-decade) time horizons, investing in 1-month T-bills and other short-dated assets creates an obvious mismatch. We recently experienced the real-world consequences of getting it wrong – albeit in the other direction – when several banks failed because their assets (U.S. Treasuries and mortgage-backed securities) had a much longer duration than their liabilities (overnight deposits).