3 Questions for Your Cash Management and Short-Term Investment Allocations

---

As financial markets adjust to the new normal of higher interest rates, elevated market volatility, and raised asset valuations, investors face the challenge of finding the optimal risk/reward balance in their portfolios.

While market consensus points to rate cuts on the horizon, predicting exactly when and how dramatic those cuts will be is difficult, making duration exposure one of the toughest decisions facing fund selectors today. This has led many to leave assets on the sidelines in cash until the path forward becomes clearer. However, that can leave uninvested clients missing out on market returns.

Investing those assets in high-quality short duration strategies can help rectify that problem. According to the 2024 Natixis Global Fund Selector Outlook Survey, 61% of respondents say they are using short-term ETFs to counter duration risk. However, not all short duration strategies are created equal.

In fact, there can be significant variation between short-term bond strategies. Volatility brought on by fluctuating interest rates, inflation concerns, and geopolitical risks over the past several years should serve as a reminder about the importance of balancing goals to seek higher relative returns while also managing risk.

One solution may be to choose an active fixed income manager. A fixed income manager who is disciplined in maintaining their short-duration posture and invests primarily in investment-grade bonds, while incorporating a robust risk management process that seeks to protect investors during market downturns, as well as reward them in more stable environments.

Here are three questions potential short-duration bond investors should be asking now, and why an ETF like the Natixis Loomis Sayles Short Duration Income ETF (LSST) could make sense for the current market landscape:

1. Does it pay to move cash into short-term bonds?
Yields across fixed income have shifted higher along with interest rates, but the Treasury yield curve has become inverted. As a result, cash-like investments such as money markets and T-Bills can offer higher annualized yields than longer duration securities. But what happens when interest rate cuts begin and the yield curve normalizes? Over recent Fed rate-cutting cycles, the total return from short-term government/credit strategies has materially outperformed their money market counterparts due to price appreciation and yield spread capture.

Short-Term Gov/Credit Outperforms T-Bills During Recent Fed Cutting Cycles

	12/29/00–6/30/03	6/29/07–12/31/08	3/29/19–3/31/20
Bloomberg 1-3 Yr US Gov/Credit Index TR	18.01%	9.77%	4.53%
Bloomberg US Treasury Bill 1-3 Months Index TR	6.46%	4.02%	2.08%
Difference (+/-)	11.55%	5.75%	2.45%

Source: Bloomberg. Past performance is no guarantee of future results.

2. Will I be taking additional risk in my short-term bond allocation?
A strategy’s standard deviation – the measurement of dispersion between performance and mean – can provide a good sense of a strategy’s overall risk level. Some short-term strategies focus on providing a higher relative yield than competitors and will bulk up on riskier, lower-rated securities to do so. Typically, strategies with larger high yield allocations experience greater performance volatility on average, producing a bumpier ride for investors. This may not be ideal for investors who pair their short-duration strategies with riskier satellite positions. Portfolios that overextend into risk could be caught in the crosshairs when volatility and credit risk spike.

Standard Deviation vs. High Yield Allocation for Short-Term Bond Funds (as of 12/31/23)

	Avg. High Yield Allocation (%)	Avg. St. Dev. (5-year trailing)
Top 20th Percentile Short-Term Bond Funds by High Yield Allocation	13.14	3.67
Short-Term Bond Category	5.40	3.25
Difference (+/-)	7.74	0.42

Source: Morningstar Direct. Past performance is no guarantee of future results.

3. Is the product “short-term” in name only?
While many short-term strategies seem to promise short duration, some will extend duration further on the yield curve for additional yield and total return. This can put portfolios at greater risk as interest rates fluctuate. For example, a short-term bond ETF with a 2-year duration will see a price decline of about -2% if interest rates rise by 1%, but a strategy that extends duration to 4 years will see that price decline double to roughly -4% in the same scenario. A -200 basis point difference may surprise and disappoint investors. As you will see from the chart below, several short-term bond funds extend their duration well beyond 2 years, and over the last 3 years, this would have produced poor results.

Total Return vs. Effective Duration for Short-Term Bond Funds (3-yr trailing as of 12/31/23)

Source: Morningstar Direct. Past performance is no guarantee of future results.

That leads us to our high-quality, short duration fixed income strategy, the Natixis Loomis Sayles Short Duration Income ETF (LSST). LSST utilizes a dynamic, active approach to sector allocation and security selection. Managed by the highly experienced Loomis Sayles Short Duration Fixed Income Team, this product incorporates top-down macroeconomic analysis combined with bottom-up security selection leveraging the depth and breadth of Loomis Sayles’ research teams. The LSST ETF can diversify in out-of-benchmark sectors, most significantly in securitized credit and below investment-grade securities, to build additional income and return potential when the team feels the risk will be rewarded. Since inception of the ETF, high yield exposure has averaged about 3%. Duration will always be maintained at roughly 2 years to provide a consistent duration experience for investors, but active yield curve positioning has the potential to provide additional alpha. LSST can be viewed as a high-quality, diversified, short-duration fixed income ETF that seeks to achieve an attractive risk and return profile relative to its benchmark.

In conclusion, investing some cash assets in high-quality, short-duration bond ETFs can be an effective strategic portfolio allocation, regardless of the future interest rate environment. When rates are rising, these strategies provide a greater level of downside protection than longer duration fixed income strategies. When rates are falling, they can outperform ultrashort and money market funds from a total return perspective due to price appreciation.

Whether you are a retiree focused on consistent income generation or a millennial saving for a down payment on a house in the near future, all types of investors can potentially benefit from diversifying away from money market funds by allocating to short-term bond strategies. And when allocating, make sure to ask the right questions about which strategy to choose.