Returns on cash to diminish; Short-term bonds offer appealing income, low volatility

The global rate-cutting cycle is expected to begin, which may impact returns on savings
Short-term bonds offer appealing yields under current market conditions
Short-term investment-grade bonds offer lower price volatility and credit risk

The global rate-cutting cycle is expected to begin, and returns from bank deposits are expected to decline. To secure steady and attractive income opportunities with lower volatility in a fluctuating market, BEA Union Investment believes high-quality short-term bonds offer juicy yields, which are compelling options that's worth a closer look.

During the pandemic, the US Fed adopted an accommodative monetary policy to prop up the economy, cutting rates to near 0% and driving consumer prices substantially higher. To combat inflation, the central bank began raising rates in 2022, pushing up the federal funds rate, which is a reference for short-term borrowing. Short-term bond rates surged as a result. Bonds with maturities under two years, in particular, now offer the most appealing yields. While a Fed policy U-turn is imminent, the US economy still exhibits resilience, with the second-quarter GDP rising 2.8%. Hence, despite the rate cut cycle being just around the corner, interest rates will likely hover at relatively high levels for an extended period of time. Consequently, short-term rates are expected to remain at attractive levels.

Short-term investment-grade bonds: Relatively low credit risks, highly defensive

Due to elevated interest rates in recent years, banks have offered reasonably attractive savings rates. However, as rates adjust downward, the allure of deposit rates is likely to fade. To generate a steady return without taking excessive risks, short-term US Treasuries and short-term investment-grade bonds both provide good income sources. Investment-grade bonds enjoy solid credit fundamentals and are highly defensive. In particular, the closer to maturity, the lower the credit risk of a bond because the likelihood of a sharp deterioration of an issuer's financial health within a short time frame is rather slim. It is also easier for rating agencies and investors to evaluate the issuer's near-term business operations. High-quality, short-term bonds offer ample investment options in both breadth and depth, with opportunities spanning across markets including the US, Europe, Japan, South Korea and Australia, and across sectors such as banks and financial services, information technology and industries, among others.

Another benefit of short-term bonds is their low sensitivity to interest rate movements. External markets will likely remain volatile. In early August, weak US job data sparked investor concerns that the country will dip into recession. In addition, steadily declining inflation led the Fed to suggest a possible rate cut in September, causing global markets to plummet. Alongside the looming US election and rising geopolitical tensions, these factors will shape the performance of US Treasuries, which in turn will affect other asset classes. However, data showed despite market volatilities, price fluctuations in short-term bonds are generally limited. The daily return of the ICE BofA 1-3 year US Corporate & Government Index hovered within the range of +/- 0.5% for the last five years. At the same time, short-term bonds benefit from greater supply and demand compared to long-term bonds, resulting in higher liquidity. This increased liquidity helps reduce mark-to-market risk for short-duration bonds.

As global inflation eases, many central banks are expected to join the rate-cutting bandwagon, which will mark the end of high savings rates. Investors should take this moment to explore the investment opportunities of short-term bonds while rates remain favourable. By employing strategies with limited risks, reduced volatility, and high liquidity, investors can secure stable income while nimbly managing funds amidst market changes.