April 2022
Sebastian Vismara, economist with BNY Mellon’s Global Economics and Investment Analysis team, shares his views on bonds and potential economic scenarios going forward.
Ultra-short bonds can offer investors two primary opportunities. First is the potential for a higher yield over a money market fund, while still maintaining a focus on principal protection and lower volatility.1 Second is the ability for investors to build more mitigation against interest-rate risk than with longer-term bond investments.
With a duration of less than one year, ultra-short bonds have less sensitivity to increasing interest rates than medium- or long-term bond funds. Ultra-short bond funds also have less credit risk when compared with longer-duration bond funds. Although return potential is also lower, an overall lower risk profile can be critical to capital preservation.
Source: BNY Mellon Investment Management. Charts are provided for illustrative purposes and are not indicative of the past or future performance of any BNY Mellon product.
Ultra-short bond funds may play an important role in a client’s asset-allocation strategy, generally providing investors with a greater yield than traditional money market funds, with lower market risk than other bond funds.1 Unlike longer-term bond funds, ultra-short products typically hold securities for a period of three to 12 months.
Ultra-short bonds come into their own when interest rates are expected to rise as they are less susceptible to rate increases.
Current market context
With US GDP rising and inflation already above the 2% target rate (year-over-year Consumer Price Index inflation: 8.55%, as of April 2022), the US Federal Reserve (Fed) has already raised the federal funds rate by 25 basis points—and has signaled further increases through 2022. The Fed started reducing the pace of its monthly bond purchases in November 2021, pulling back on the amount of help it had been providing markets and the economy having once spent US$120bn a month buying assets such as Treasuries and mortgage-backed securities. Shrinkage in the Fed’s balance sheet, also known as quantitative tightening (QT), may start as early as after the Fed’s meeting in May.
Market-based monetary policy expectations
In first quarter 2022, markets priced in a tightening in monetary policy globally. The United States saw a major shift in policy expectations. Following the first rate hike in March, the market is currently pricing around ten 25 basis-point hikes over the next year, with around one additional hike priced in afterwards. With inflation expected to fall back around target only gradually over the next years, and real rates close to 0% across the curve, effectively, the market expects inflation to fall to levels closer to target on the back of just a modest tightening by the Fed in real terms. To some extent, the market is providing a similar signal in a number of developed markets, as hike expectations are heavily front-loaded but capped at a relatively low rate, particularly in real terms.
“More broadly,” says Vismara, “there are a number of potential scenarios that could play out based on the post–pandemic economic recovery and the war in Ukraine.”
In scenario one, in particular, the resulting market environment could be an opportunity for ultra-short bonds.
Scenario 1: Best case (35% probability)
- The conflict is short.
- Energy prices fall back in second half 2022.
- Monetary policy tightens gradually.
- Inflation falls, and growth stabilizes.
- Market liquidity returns, and risk assets make progress.
Scenario 2: Inflation surges (10% probability)
- The conflict is short.
- Energy prices stay high.
- Monetary policy is left too loose for too long.
- Core inflation stays high.
- Inflation expectations and wage growth shift up.
- Inflation mostly happens outside Europe.
- There is a tricky outlook for fixed income and risk assets.
Scenario 3: Widespread recession (35% probability)
- The conflict is prolonged.
- Energy prices continue to rise.
- Real incomes fall sharply in energy-importing countries.
- Recession potentially worsened by monetary tightening.
- The world moves into recession, and core inflation falls.
- Risk assets hit hard initially, but pick up sharply.
Scenario 4: Liquidity crunch (20% probability)
- Financial sanctions have unintended consequences via Western counterparties.
- Market liquidity dries up—sharp widening of bid-ask spreads, risk premia, etc.
- Central banks are unable to offset fully thanks to inflation constraint.
- Markets sell off sharply, tightening financial conditions and hitting growth hard globally.
Summing up, while our scenarios lay out many perilous paths, it’s worth keeping in mind just how much uncertainty is being priced by the market. That markets are almost universally down this year may in hindsight prove an over-extrapolation of bearish sentiment, because not all uncertainties are tinged with “doom and gloom.”
That said, we think the likelihood of further negative surprises remains elevated, with further market de-risking a material possibility.
Introducing the BNY Mellon Ultra Short Income ETF: BKUI
- The fund seeks to provide income while also targeting low volatility and maintenance of liquidity.
- The fund may be appropriate for investors looking for more attractive yields than what money market vehicles may provide, while also focusing on volatility management and downside protection.2
- The experienced cash management team focuses on total return, with active risk management.
- A liquid ETF structure allows investors to buy or sell any time the market is open.
1 The risks of investing in ultra-short bonds are higher than investing in money market funds. In addition, ultra-short bond funds are not subject to the liquidity requirements and investment and credit quality restrictions applicable to money market funds. There can be no assurance that ultra-short bonds will protect principal or generate higher returns than money market funds.
2 The fund is not a money market fund, and the risks of investing in ultra-short bond funds is higher than investing in money market funds. In addition, ultra-short bond funds are not subject to the liquidity requirements and investment and credit quality restrictions applicable to money market funds. There can be no assurance that the fund will protect principal or generate higher returns than money market funds.
Investors should consider the investment objectives, risks, charges, and expenses of an ETF carefully before investing. To obtain a prospectus, or summary prospectus, if available, that contains this and other information about an ETF, contact your financial professional or visit im.bnymellon.com/etf. Read the prospectus carefully before investing.
ETF shares are listed on an exchange, and shares are generally purchased and sold in the secondary market at market price. At times, the market price may be at a premium or discount to the ETFs per share NAV. In addition, ETFs are subject to the risk that an active trading market for an ETF’s shares may not develop or be maintained. Buying or selling ETF shares on an exchange may require the payment of brokerage commissions.
ETFs trade like stocks, are subject to investment risk, including possible loss of principal. The risks of investing in ETFs typically reflect the risks associated with the types of instruments in which the ETF invests. Diversification cannot assure a profit or protect against loss.
Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. Commercial paper is a short-term obligation with a maturity generally ranging from one to 270 days and is issued by US or foreign companies or other entities in order to finance their current operations. Such investments are unsecured and usually discounted from their value at maturity. Investing in foreign-denominated and/or domiciled involves special risks, including changes in currency exchange rates, political, economic, and social instability, limited company information, differing auditing and legal standards, and less market liquidity. These risks generally are greater with emerging market countries.
The ETF will issue (or redeem) fund shares to certain institutional investors known as “authorized participants” (typically market makers or other broker-dealers) only in large blocks of fund shares known as “creation units.” BNY Mellon Securities Corporation (BNYMSC), a subsidiary of the BNY Mellon, serves as distributor of the fund. BNYMSC does not distribute fund shares in less than Creation Units, nor does it maintain a secondary market in fund shares. BNYMSC may enter into selected agreements with authorized participants for the sale of creation units of fund shares.
Past performance is no guarantee of future results.
Recent market risks include pandemic risks related to COVID-19. The effects of COVID-19 have contributed to increased volatility in global markets and will likely affect certain countries, companies, industries and market sectors more dramatically than others.
This material has been provided for informational purposes only and should not be construed as tax advice, investment advice or a recommendation of any particular investment product, strategy, investment manager or account arrangement, and should not serve as a primary basis for investment decisions. Prospective investors should consult a legal, tax or financial professional in order to determine whether any investment product, strategy or service is appropriate for their particular circumstances. Views expressed are those of the author stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change.
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