With a flatter curve, less duration can be more

Short-duration bonds offer attractive yields with less exposure to rate volatility as the Treasury curve flattens.

• The 10-year Treasury yield rose from just below 4.5% at the start of the third quarter to just below 5.3% at its close, an 80-basis-point quarterly increase.
• Two-year Treasury yields are not much lower than 10-year yields, while the modest term premium limits the compensation for holding longer duration.
• Short-term yields are more sensitive to Federal Reserve policy, whereas longer-term yields reflect capital competition, inflation expectations and economic strength.
• In a sticky soft-landing scenario, one- to three-year strategies could remain nimble without requiring a precise call on rate cuts, while investment-grade credit is favored over high yield.
• In a stagflation-lite scenario, ultra-short and floating-rate bonds could reprice automatically if the Fed hikes, and investment-grade credit should benefit from stronger balance sheets than high yield.

Takeaway: Investors may capture much of the benefit of bonds in a soft landing by favoring short duration, while limiting exposure to the risks of renewed inflation and abrupt rate increases.