In brief:

• Towards the end of the economic cycle, it is important to focus on potential total returns rather than just yields.
• The recent period of rising yields isn’t necessarily an appropriate guide for mapping out future potential total returns.
• Falling bond yields provide a good environment for step out strategies to outperform.
• Be careful not to take too much credit risk in the pursuit of yield just before a potential recession.

When comparing short-term money market strategies with step out strategies such as standard money market or ultra-short duration bond strategies, it’s important to consider the future total return potential rather than just today’s yield.

A bond’s return comes from both its income and any change in its price. So just focusing on the yield doesn’t tell you about the potential gains (or losses) from changes in the price of the bond.

Blinded by yields

Towards the end of an economic cycle, interest rates tend to be elevated and unemployment tends to be low. In this late stage of an economic cycle, the yield on longer dated bonds can fall below the yield on shorter dated bonds (which is called a yield curve inversion). This happens because the market starts to predict that the current high interest rates will weigh on the economy and eventually lead to a recession that will cause inflation to fall and central banks to respond by cutting interest rates to stimulate growth.

Towards the end of an economic cycle, the highest yields can therefore often be found on the shortest dated bonds. However, the price of longer duration bonds responds by more than shorter duration bonds to changes in their yield. So there are times, particularly towards the end of an economic cycle, when it can make sense to buy a longer duration bond with a lower yield than a shorter duration bond to benefit from the greater potential increase in the longer duration bond’s price if a recession does arrive and interest rates fall by more than is priced in. Investors who focus only on yield could miss out on this potential outperformance that step out strategies can benefit from as a result of being able to extend their duration beyond that of short-term money market strategies.

Recent history can obscure the future

It's important to be forward-looking, rather than driving through the rear-view mirror. We’ve been through one of the fastest periods of rising bond yields in recent history, so comparing the backward-looking total returns of step out strategies with the returns of short-term money market strategies in a period of rising bond yields doesn’t give a good insight into the potential future outperformance of step out strategies when yields fall. During a period of rising interest rates and bond yields, step out strategies will have wanted to shorten their duration as much as possible. The ability to lengthen duration really becomes an advantage for step out strategies when bond yields are about to fall, as tends to happen during a recession.

Consider credit risk

Another reason not just to focus on yield when comparing strategies is that towards the end of an economic cycle, credit spreads tend to be quite tight. Step out strategies can take more credit risk than short-term money market strategies, so a step out strategy with significant credit risk would have a higher yield than one that was more cautiously positioned on credit. Yet in a recession, credit spreads tend to widen and so a higher yielding strategy could underperform a lower yielding strategy because of its higher credit risk. 

In summary, towards the end of an economic cycle focusing too much on yield and not enough on future potential price changes in the underlying bonds could encourage an investor to hold less duration and more credit risk than normally makes sense at this point in the economic cycle. Step out strategies that can extend their duration while choosing to maintain a relatively cautious credit position might not have the most attractive yield but could outperform strategies with less duration and/or more credit risk in a recession. 

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