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.

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