September 15, 2020

Fed’s More Flexible Inflation Target

Profile picture for user Peter Duffy
Peter Duffy, CFA
CIO - Credit, Sr. Portfolio Manager

Last week the Federal Reserve officially announced what we already assumed; their desire to stoke inflation over 2%.

Instead of taking proactive measures when inflation reaches 2%, or even prior to 2%, the Federal Reserve ("Fed") will now instead look at the “long-run” inflation average and act accordingly. The Fed may allow inflation to reach over 2.5% so long as they believe that over the long-run inflation will average down to 2%. That provides the Fed with enough discretion, and flexibility, that inflation expectations, not to be confused with actual inflation, might inch higher.


The Fed’s comments come at a somewhat precarious time for the longer end of the US Treasury curve since the Federal government, already in deficit-spending mode pre-COVID-19, is teed up to borrow trillions for pandemic relief. So what does all of this mean for the bond markets?

First, short-term interest rates, which follow the Fed’s lead, should be well anchored for the foreseeable future. Second, since the Fed does not control long-term interest rates (inflation expectations do), you may see a sustained steepening of the US Treasury curve where longer term rates trend higher while the short end of the curve is less impacted.


In turn, that means credit exposure should be monitored for its duration. Duration has long been the friend of the corporate bond market. Other than a few blips, the 10-year minus 2-year Treasury yield curve has been flattening consistently since the beginning of 2014. The temptation may be to assume that this trend continues, but what if it doesn’t? What if the steepening “blip” that we have seen here in 2020 continues?


As of August 25, 2020, the yield-to-worst (“YTW”) on the ICE BofA US Corporate Index was 1.98% and duration stood at 8.1 years. That results in a yield per unit duration of 25 basis points; about half of its 2014 starting value since both yields have fallen and duration has increased since then (YTW of 3.21% and 6.9 years). As of August 25th, a similar reduction in yield per unit of duration can be seen in the Bloomberg Barclays US Aggregate Bond Index (“Agg”); YTW was 1.16% and duration was 6.3 years compared to the start of 2014 when the Agg sported a YTW of 2.48% and duration of 5.6 years.

That is low compensation for taking such duration risk, which is why those higher quality fixed income asset classes perform relatively poorly against shorter duration credit-sensitive assets during periods of rising rates.

The extension of duration and declining yield environment was met head-on with the aftermath of a massive market dislocation where the Fed was more aggressive than ever. This allows fixed income asset allocations ripe for reassessment, especially when it means being contrary to consensus views that long-term rates will never break out to the upside.

With strong current yields coupled with duration below 2 years, adding a high-quality high yield short duration sleeve may help to optimize a fixed income asset allocation that suffers from longer durations and lower yields.



A PDF Version can be found here.


This is for informational purposes only and is not a recommendation to buy or sell a specific security.

The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Under no circumstances should this information be construed as a recommendation or advice. The views expressed herein reflect the professional opinions of the portfolio managers and are subject to change. Penn Capital does not accept any liability for losses either direct or consequential caused by the use of, or reliance upon, this information. These views are subject to change at any time and they do not guarantee future performance of the markets. Investing in the stock market involves gains and losses and may not be suitable for all investors. Investors have the opportunity for losses as well as profits.

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Penn Capital), or any non-investment related content, made reference to directly or indirectly contained within this commentary be suitable for your portfolio or individual situation, or prove successful. Comparisons to indices are inherently unreliable indicators of future performance. The strategies used to generate the performance vary from those used to generate the returns depicted in the benchmarks. Penn Capital makes no representation as to the methodology used to generate the benchmark returns. Portfolio holdings are subject change and may or may not be held by one or more Penn Capital portfolios from time to time. Transactions in such securities may be made which seemingly contradict the references to them for a variety of reasons, including but not limited to, liquidity to meet redemptions or overall portfolio rebalancing.

Indices are unmanaged and not available for direct investment. Index comparisons have limitations because indexes have volatility and other material characteristics that may differ from a particular investment. Index performance does not reflect deductions for fees, expenses or taxes. Benchmark returns are not covered by the report of independent verifiers. Note that comparing the performance to a different index might have materially different results than those shown. The ICE BofA US HY Cash Pay BB-B Rated 1-3 Year Index is a subset of The Bank of America US Cash Pay High Yield Index, which tracks the performance of non-investment-grade corporate bonds with a remaining term to final maturity less than three years and rated BB-B. The ICE BofA US High Yield Index tracks the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market. The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed rate taxable bond market. The ICE BofA US Treasury Index tracks the performance of the US dollar denominated sovereign debt publicly issued by the IS government in its domestic market. The ICE BofA US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market. The ICE BofA US Municipal Securities Index tracks the performance of U.S. dollar–denominated investment grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions, in the U.S. domestic market. The ICE BofA US Mortgage Backed Securities Index tracks the performance US Mortgage Backed Securities Index.