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Quick Takes: Why Short Term Bonds Are Especially Defensive Today

Andrew Wittkop, executive vice president and portfolio manager, discusses the merits of short duration strategies for investors concerned about rising interest rates and increased volatility. For more information, please visit www.pimco.com/cash-management.

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Andrew Wittkop: Investors have closely been monitoring the increase in U.S. interest rates.

The move has been caused by the Federal Reserve continuing to normalize their policy rate after years of zero-interest-rate policy follow the great recession.

The Federal Reserve's own expectation is that they will hike a total of three times in 2018, and eventually reach just under 3.5% for their policy rate by the end of 2020.

Investors concerned about the potential for rising rates and increased volatility should consider short-duration strategies. This is a way to be more defensive against rising yields.

The following chart shows how much yields need to approximately rise in order for different fixed income strategies to experience negative absolute returns over a one-year holding period.

The red line, which is a proxy for short-duration strategies, shows that rates would need to rise over 450 basis points from current levels before returns were negative. This is four to nine times greater than other fixed income strategies that have more duration.

What is also noticeable from this chart is how much more of a buffer short-duration strategies currently offer compared to just a few years ago.

If I go back to 2015, almost equal moves higher in yields across all fixed income strategies would have caused negative absolute returns.

So why is this the case today? The reason why differentials are now so wide is due to the fact that, unlike a few years ago when the yield curve was steep, the yield curve is now at its flattest level over the last decade.

What this means is that investors are not demanding much more incremental yield to extend their maturity profile.

So what is the key takeaway for investors? Investors concerned about rising rates and increased market volatility should consider short-duration strategies as a potential solution.  This is a way to be more defensive against rising yields.

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