The Federal Reserve is telegraphing multiple rate hikes in 2017, as unemployment remains low and the economy shows continued stability after the financial crisis. From the summer of 2016, the yield on the two-year U.S. Treasury has already roughly doubled from below 0.60% to more than 1.20%. And over the past five years, the yield has quadrupled. The prospect of rising interest rates, in turn, has focused new attention on short-term bond funds.

By their very nature, bonds that mature sooner rather than later have less interest rate sensitivity or “duration,” since the capital invested in them can be redeployed relatively quickly at new, higher rates. Individual bonds and bond funds have a duration statistic that is related to when investors will receive their money, but it’s also useful for understanding how interest-rate sensitive a bond or a bond fund will be. For example, the average duration for institutional funds in Morningstar’s short-term bond category is two years—which implies that a 1% increase in Treasury rates will send a fund down 2%.

The problem is that rates are still so low that it’s difficult for investors to achieve an inflation-beating return in short-term bonds. The average 12-month yield for funds in Morningstar’s short-term bond fund category is a paltry 1.8%. Short-term bond indexes are yielding even less. The Vanguard Short-Term Bond Index Fund (VBITX), which tracks the Bloomberg Barclays U.S. 1-5 Year Government/Credit Float Adjusted Index, has a 12-month yield of around 1.5%.

The Quest For Yield
For this reason, a lot of managers are laying off low-yielding government debt and agency mortgages. A 1.2% yield on a two-year U.S. Treasury, after all, becomes significantly less than 1% after factoring in the typical fund’s expense ratio.

To tackle this problem, the DoubleLine Low Duration Bond Fund (DBLSX), for instance, invests 11.5% in non-agency mortgage-backed securities, another 15% in commercial mortgage-backed securities (CMBS), 7% in asset-backed securities, 18% in dollar-denominated emerging markets debt and 16% in collateralized loan obligations whose underlying assets are floating-rate corporate bank loans.

According to Philip Barach, the lead manager on the fund, a good chunk of the non-agency mortgages are “AAA”-rated. The fund’s cost basis is 99.8 for what he says are very seasoned loans with high yields to maturity (around 3.4%). The duration of these investments is 1.4 years, so the yield-to-maturity statistic is almost three times the duration. DoubleLine managers take this “yield-to-duration” statistic seriously to make sure they’re getting paid enough for the duration risk they’re taking. Regarding the fund’s non-agency paper, Barach notes, “There’s very little supply of them, and in market selloffs, there’s very little selling going on. If we could find more, we’d increase our position.”

Barach owns almost no agency MBS in the fund. Referring to the deceleration of mortgage prepayments that occurs when rates are increasing, he says, “It’s hard to find agency MBS which will always be short term. It could extend out. For this type of fund, we’re not willing to take that risk.”

In emerging markets, DoubleLine has long favored buying dollar-denominated bonds. The firm’s stance on the dollar is less rigid now, after the greenback’s strong run, but the fund’s allocation still reflects a preference for dollar-denominated credits. Barach notes that the fund’s emerging markets bonds are mostly investment grade and carry a maturity of two to three years and a duration of around two and a half years. These types of bonds displayed low volatility in the period from May to December of 2013 when other bonds struggled. Barach argues the allocation gives him more than 100 basis points of yield pickup without much extra credit risk.

Barach also likes CLOs, because they are composed of underlying floating-rate loans giving them virtually no duration risk. The fund’s holdings in this area have a yield to maturity of around 2.3%, and the majority of the tranches the fund owns are “AAA”-rated.

The CMBS portion of the portfolio has a yield to maturity of 2.8% and, as Barach says, “That yield is well above duration.” The fund’s commercial mortgage-backed securities are also investment grade. Most are seasoned bonds that provide incremental extra yield, and should outperform inflation while remaining stable. With its expertise in mortgages and real estate, DoubleLine has been aware of problems in the retail sector, but thinks its holdings are protected. As Barach notes, “JCPenney is not going bankrupt soon. I wouldn’t want to buy long-term CMBS, but the analysis of the short-term portfolio is very different.”

Another fund worth considering is the Prudential Short Duration Multi-Sector Bond Fund (SDMQX). (PGIM is the name for the rebranded Prudential Investment Management.) Mike Collins, PGIM Fixed Income’s senior investment officer and portfolio manager, and his team have a large tool kit. Currently, they are fond of asset-backed securities, including non-agency mortgages and securitized consumer loans.

While some asset-backed securities carry risk, including exposure to subprime auto loans, Collins says, “We’re trying to focus on the underwriters that are the best. Some private entities called ‘shadow banking’ are over their skis.” Mortgages still make up 85% of consumer debt, says Collins, and he’s been limiting exposure to entities he thinks are the most solid from a credit perspective.

The PGIM team also likes commercial mortgage-backed securities, which make up just over one-third of the portfolio. Collins says they yield more than 200 basis points over a comparable Treasury. But CMBS is not without its warts. Some securities issued five years ago were heavy in retail, and Collins notes, “We tried to steer away. Apartments have done incredibly well, but some of that is overbuilt, and we’re careful about that.” Lodging is a property type the team favors now.

The fund also has around 20% of its portfolio in investment-grade corporate bonds, mostly in the one-to-five-year range, and Collins has arranged that part of the portfolio in a way that resembles a typical bond ladder. Investment-grade bonds are less volatile than high-yield corporates, and they provide the portfolio with a measure of stability. Collins notes that this type of portfolio hasn’t experienced an annual loss since 1994 when the Fed unexpectedly raised rates. He particularly likes financials now. Banks have been heavily regulated since the financial crisis, and their risks have been reduced accordingly. He also likes some consumer-oriented sectors, health care and telecom. Collins’ sector weightings reflect his bullishness on the consumer.

Moreover, ultra-short-term corporates (“commercial paper”) are trading at attractive prices because of the SEC’s new regulations on money market funds. As more money market instruments are purely invested in government securities, they’ve had to sell off commercial paper, causing it to trade at attractive prices.

This fund is in the top 10% of the Morningstar category for the three-year period ending in March 2017, but it wobbled a little more than the others highlighted here during the credit hiccup of late 2015. The fund dropped 0.18% in the second quarter of that year, 0.34% in the third and 0.47% in the fourth.

Another fund that likes investment-grade corporates and commercial paper is the heavyweight in the category, the $40 billion Lord Abbett Short Duration Income Fund (LLDYX). Like his peers at PGIM, manager Andrew O’Brien, speaking to Financial Advisor, said that money market reform has left a lot of commercial paper “without a natural home.”

Short-term bond managers might also see a noteworthy opportunity in asset-backed securities. O’Brien says this is a liquid asset class where credits associated with commodities have done well for the past year. The fund tends to use “AAA”-rated asset-backed securities the way other funds use Treasurys—as something to hold onto while they wait for better opportunities to present themselves. O’Brien views these securities as safe, and they’re providing a modest yield pickup right now—Libor plus 15 to 25 basis points. The fund has roughly 15% of its assets in ABS now.

The fund exchanged a substantial amount of high-yield exposure for its current investment-grade stake. At its peak, the fund had 24% of its assets in high-yield bonds; now high yield is 10% of the portfolio. High-yield bonds tumbled at the end of 2015, and came roaring back throughout 2016. O’Brien notes that high yield is not as compelling as it was six months ago.

He also notes that the fund’s size isn’t a problem because of its diversification. Having $40 billion in one sector might be burdensome, but $25 billion in investment-grade corporates and $10 billion in CMBS is manageable. O’Brien says, “CMBS is the most size-constrained area, but when we look at what percentage of the fund is there, we realize we could probably have two times the amount of assets there without a problem.” There are also advantages to being big. O’Brien notes that the fund can provide liquidity, swooping in and buying a block of assets from a motivated seller in a way that others can’t.

Regarding the 25% slug in CMBS, O’Brien notes that the asset class is slightly less compelling now, but still decent. The fund has participated in deals that places it high in the capital structure. There are some challenging fundamentals, but valuations are still reasonable. The fund is also participating in some concentrated deals—a hotel chain, for example—where some diversity is lost but the underwriting standards are tighter.

Among corporates, the fund is partial to financials, and also has a big energy overweight. Bank lending standards are much tighter now, so “BBB”-rated banks are still very solid. It’s harder for banks to be as profitable as they were before, but that hurts the equity holders rather than debt holders.

For those concerned about the credit risks the fund takes, O’Brien noted that it held up well in 2008 when it lost 0.42% and wound up in the top half of the Morningstar short-term bond category. The next year, the fund screamed back with a 17% return, good enough to land it in the top 4% of the category. The fund takes some risks, but it has a proven ability to handle them well.

While DoubleLine, Lord Abbett and PGIM take some risks, a fourth fund, the Metropolitan West Low Duration Bond Fund (MWLIX), is easing off the gas pedal. The fund has 26% of its portfolio in U.S. government bonds, which is nearly double the average exposure of funds in Morningstar’s short-term bond category. Also, the fund has another 8% of its portfolio in cash.

Longtime manager Tad Rivelle thinks we’re late in the credit cycle and investors generally aren’t being compensated for taking credit risk. Rivelle quotes Benjamin Graham in describing bond investing as a kind of “negative art” that’s designed to avoid losses or bad outcomes more than gun for gains. And if that’s normally the case with bonds, it’s especially the case now.

Still, Rivelle has made some moves to earn investors a decent yield. Although he owns almost no high yield and emerging markets debt, he owns corporate bonds, mostly utilities and financials and some consumer staples. Banks are now much more regulated than they were before the financial crisis.

Rivelle has another 7%-8% of the portfolio in asset-backed securities—specifically, U.S. government guaranteed student loans. These are floating-rate loans with uncapped features on their yields providing good inflation protection.

Still another roughly 8% of the portfolio is in CMBS. This includes loans on different property types, and Rivelle owns very highly rated tranches that he says would only be impaired in the event of a 30% to 40% loss on the underlying loans.

Like other bond managers, Rivelle owns some subprime non-agency mortgages dating from the financial crisis. Those that still exist represent good value, in his opinion. The borrowers of remaining loans are making their payments, and the bonds sell at discounts. According to Rivelle, “The credit curing process continues to unfold. So there are defensive securities that can provide between 2% and 5% without bearing much risk.”

Lastly, Rivelle is trying to arbitrage the appetite of foreign investors to own U.S. dollars. Specifically, he is buying short-term Japanese sovereign debt and hedging the currency exposure with a forward contract. That provides a 1.25% to 1.50% annualized return for a 90-day investment for taking Japanese sovereign risk.