A Multi‑Sector Approach to Short‑Term Bonds
- The low duration portfolio management team applies a multi‑sector approach as we strive to capture an appropriate amount of risk‑adjusted yield.
- The multi‑sector approach reduces the fund’s dependence on any particular market and can help capture relative value across sectors.
- Actively managing liquidity risk is a key component of our analysis of bond market sectors and the fund’s allocations.
The low duration portfolio management team believes a multi‑sector approach is the best way for a short‑term bond portfolio to provide incremental income while taking less credit and interest rate risk than longer‑maturity fixed income funds1. This reduces the portfolio’s dependence on any particular market and can help capture relative value across sectors2. We combine this approach with rigorous fundamental credit analysis to inform our security selection and potentially help avoid downside scenarios as we strive to capture an appropriate amount of risk‑adjusted yield. Actively managing liquidity risk is a key component of our analysis of bond market sectors and the fund’s allocations.
The Short-Term Bond Fund is an investment‑grade portfolio that can invest in a range of sectors, both in and out of benchmark. The Bloomberg Barclays 1–3 Year U.S. Government/Credit Bond Index benchmark includes Treasuries, agency debt, and investment‑grade corporate bonds.
The fund also has the flexibility to invest in sectors that are not in the benchmark, such as securitized debt, which includes government‑guaranteed agency mortgage‑backed securities (MBS) as well as segments with credit risk, such as non‑agency mortgage‑backed securities (RMBS), commercial mortgage‑backed securities (CMBS), and asset‑backed securities (ABS). The drivers of credit quality in these securitized markets often differ from those affecting investment‑grade corporate bonds.
This multi‑sector approach provides diversification3 and allows us to try to take advantage of relative value opportunities based on the market environment and potential dislocations in valuation. When determining allocations across the various sectors, we can draw on the expertise of our global sector research specialists. We measure relative valuation in terms of yield or credit spread,4 adjusted for volatility to manage risk and help ensure that we do not simply chase riskier sectors that have been outperforming in a positive market.
"…we actively manage the fund’s exposure to liquidity risk."
We also diversify exposures within sectors. For example, within the fund’s allocation to investment‑grade corporates, we manage exposure across industries as well as domestic versus international issuers. We are currently avoiding industries we think will experience negative structural change due to COVID‑19 (the disease caused by the coronavirus), such as travel and leisure. Within securitized credit, we can diversify across types of bonds with different cash flow structures and varying credit risk.
Credit Analysts Inform Security Selection
At the security selection level, we rely on T. Rowe Price’s global team of credit analysts to provide insight into the fundamental condition of individual issuers and the structures of specific bonds. Corporate credit analysts specialize in particular industries, while securitized credit analysts develop expertise in segments like RMBS and ABS. We believe that research input from the credit analysts adds value over time through strong security selection and enhances the strong foundation provided by our multi‑sector approach.
Active Management of Liquidity Risk
Liquidity in many fixed income sectors became limited in March as financial market participants realized the likely extent of the economic damage from the coronavirus pandemic. Although liquidity has improved meaningfully after the Federal Reserve implemented various programs to support fixed income market segments, we actively manage the fund’s exposure to liquidity risk. This may help us navigate periods of extreme market stress, such as March 2020 and the depths of the global financial crisis in 2008–2009.
The different fixed income sectors have distinct liquidity profiles. Treasuries are the most liquid bonds, while investment‑grade corporates can present more challenges for buying and selling at efficient prices. We seek to address this by laddering, or structuring the fund’s corporate bond holdings so that they mature at regular intervals, and by generally favoring shorter‑maturity corporates for their typically better liquidity. We learned in March that securitized credit instruments can have surprisingly limited liquidity at times. However, unlike most corporate bonds, securitized debt pays down principal over time, which is another way to potentially generate organic cash flow in the portfolio.
Structural Allocation to Treasuries for Liquidity
Liquidity considerations are a key component of our multi‑sector approach. The fund has a structural allocation to Treasuries that should benefit from their liquidity even when trading at efficient prices in other sectors becomes limited. In addition, we ladder the fund’s corporate debt exposure in striving to provide the fund with predictable small increases in cash without relying on selling holdings.
WHAT WE’RE WATCHING NEXT
As always, we rely on rigorous fundamental analysis to drive our investment decisions. We are closely collaborating with our corporate credit analysts and global economists to gauge the impact of the coronavirus pandemic on corporate earnings. Amid the ongoing uncertainty about the pace of reopening businesses and the economic recovery, the range of consensus expectations for corporate earnings has grown much wider. We believe that this may produce more opportunities to find individual corporate bonds with prices that do not accurately reflect their fundamentals.
1 The fund’s income level should generally be less than that of a long term bond fund.
2 Relative value is a qualitative assessment of pricing and risk across sectors, industries, or securities.
3 Diversification cannot assure a profit or protect against loss in a declining market.
4 Credit spreads measure the additional yield that investors demand for holding a bond with credit risk over a similar‑maturity, high‑quality government security.
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This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of July 2020 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
Debt securities could suffer an adverse change in financial condition due to a ratings downgrade or default that may affect the value of an investment. Fixed income securities are subject to credit risk, liquidity risk, call risk, and interest rate risk. As interest rates rise, bond prices generally fall. Mortgage-backed securities are subject to credit risk, interest-rate risk, prepayment risk, and extension risk. The fund is subject to these risks and market risk, as well as risks associated with unfavorable currency exchange rates and political economic uncertainty abroad. A lack of liquidity or other adverse credit market conditions may hamper the fund’s ability to sell the debt instruments in which it invests or to find and purchase suitable debt instruments.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.
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