Should investors go short duration in anticipation of a taper?

Market Realist

Fixed income recap: Key ideas for the week of December 2 (Part 1 of 3)

Yield curve flattens slightly on the short week

We didn’t see a lot of movement on the yield curve last week, as the short end widened 1 basis point and the long end tightened 2 basis points. The 5s7s spread (the difference between the yields on the five-year and the seven-year Treasury notes) stayed at year-to-date highs of 73 basis points. This steepening of the curve over the course of the year has been driven primarily by an increase in real interest rates, since inflation expectations (the difference between nominal and real interest rates) have actually fallen since January.

Investors in the iShares 20+ Year Treasury ETF (TLT) should note the flatness of the 10s30s spread. It may appear that you’re not getting very well compensated for holding the longer-maturity bonds, but when rate volatility goes up, you’ll be protected by the fund’s convexity profile, since higher-convexity bonds are hurt less by increases in interest rates. In fact, the annualized rate volatility of the ten-year has been 33.6% in 2013, versus only 21.4% for the 30-year. That being said, the higher duration of the 30-year means the rising rate environment has hit the long bond’s dollar value hard.

With so much upward momentum in real rates and the Fed itching to taper, it might make sense to be short duration through an allocation to the iShares 7-10 Year Treasury ETF (IEF) versus TLT.

Read on to learn how investment-grade spread products performed last week.

Continue to Part 2

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