2018 Was a Litmus Test
After a couple of years lagging many other more-aggressive bond categories, short-term bond funds were relatively strong performers in what proved to be a difficult environment for bonds in 2018. The most obvious influence through most of the year was the Federal Reserve’s slow and steady hiking of short-term interest rates. In the second half of the year, pressure on the credit markets increased further, as expectations for U.S. economic growth and inflation were pared back. Even though yields rallied in the last two months of the year, short still trumped intermediate for the full year; the broad short-term bond Morningstar Category delivered 0.92%, while the broad intermediate-term bond Morningstar Category lost 0.50%.
A second and related phenomena was that the yield curve continued to flatten during 2018. As my colleague Miriam Sjoblom pointed out in early 2018, a flattening yield curve narrows the additional yield that an investor is getting paid to take interest-rate risk, so from a fundamental perspective, short funds begin to look more attractive. This happened over the course of the year, as the Federal Reserve tightened monetary policy by raising interest rates four times: in March, June, September, and December. The yield curve flattened considerably, and the spread between the 10-year and 2-year U.S. Treasury tightened, from 54 basis points at the start of the year to 21 basis points at close. Also, by definition, short-term bond funds have less duration, or interest-rate risk, than many longer-maturity-focused options, and this structural characteristic was a significant boon to performance over the course of the year. In short (an intentional pun), investors weren’t giving up that much more yield by not taking additional interest-rate risk.
Emory Zink does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.