After pausing its aggressive tightening campaign in 2023, the Federal Reserve (Fed) made a series of rate cuts in late 2024, reducing the federal funds rate by 1%. While the Fed is expected to resume cutting rates at some point, the timing remains uncertain and continues to shift in response to evolving economic data. This presents a challenge for investors who have been earning attractive yields in money markets and Treasury bills. At the same time, with recession fears easing and investor sentiment improving, selectively taking credit risk to enhance income may be a prudent strategy. One potential solution is short duration high yield bonds — an asset class that combines relatively high income potential with low interest-rate sensitivity and a history of strong risk-adjusted returns.
Reinvestment Risk: The Hidden Cost of Cash
Short-term Treasury bills have attracted considerable investor attention over the past few years, offering yields above 5% for a time, with minimal duration risk. However, those elevated yields declined following last year’s rate cuts by the Fed. Moreover, those yields are locked in for relatively short time frames — making them highly sensitive to changes in the policy rate. As the Fed continues its easing cycle, reinvestment risk becomes increasingly important: Investors who roll short-term Treasury bills may find themselves reinvesting at progressively lower yields.
To illustrate this risk, we modeled three hypothetical paths for the 3-month Treasury rate over the next three years. In one scenario, the rates remain flat over the entire period, an unrealistic assumption, but useful for comparison. In the other two scenarios, they decline gradually in one and sharply in the other. In each case, the actual realized yield over the full period is significantly lower than the initial rate. By contrast, a bond issued by a BB-rated aerospace company — an S&P 500 constituent — offers a 5.6% yield to maturity with three years remaining until maturity. In a falling rate environment, locking in that yield today offers a meaningful advantage over the ongoing reinvestment of short-term instruments.
Hypothetical 3-Month Treasury Yield Paths
Source: ICE Data, as of 6/30/25. Data shown is hypothetical and does not represent any specific investment. For illustrative purposes only.
Responding to a Year of Diverging Rate Trends
Last year highlighted the challenges of navigating a divergent rate environment. Yields at the short end of the curve declined, eroding income for cash investors, while longer-duration bonds faced principal losses as long-end rates moved higher. These opposing forces created a difficult environment for many fixed income strategies—where both reinvestment and duration risk were in play.
Short duration high yield stood out by striking a balance between credit and rate sensitivity. Its limited interest rate exposure helped avoid the volatility seen in longer-duration bonds, while benefiting from a supportive credit backdrop. As a result, short duration high yield returned 7.1% in 2024, outperforming Treasuries, core bonds, and investment grade corporates.
Navigating Reinvestment Risk and Duration Risk
2024 Performance
Source: FactSet s of 6/30/25. Yield to maturity (YTM) is the total rate of return earned when a bond makes all interest payments and repays the original principal. Short Duration High Yield represented by ICE BofA High Yield 1-5 BB-B Index, Bloomberg Agg represented by Bloomberg U.S. Aggregate Index, IG Corporate represented by ICE BofA U.S. Corporate Index , U.S. Treasuries is represented by Bloomberg U.S. Treasury Index and Global Aggregate represented by Bloomberg Global Aggregate Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Evaluating Risk-Adjusted Returns Across Fixed Income
Understandably, investors often associate high-yield bonds with elevated credit risk. But risk should be viewed through the lens of compensation. Over the past decade, short duration high-yield bonds have delivered strong performance – both on a risk adjusted and absolute basis. This segment of the high yield market not only exhibits lower interest rate sensitivity, but also tends to be less exposed to credit volatility due to its bias toward higher-rated (BB) issuers. These characteristics have contributed to its consistency across different market environments.
Measured by the Sharpe ratio, which considers returns relative to volatility, short duration high yield outperformed many fixed-income sectors — including investment-grade corporates, U.S. Treasuries, and the Bloomberg Aggregate Bond Index. This superior risk-return profile suggests that short-duration high-yield investors have been compensated not just with higher yields, but also with stronger returns per unit of risk.
Ten Years ending June 30, 2025
Source: Morningstar as of 6/30/25. Short Duration High Yield is represented by ICE BofA 1-5 Year BB-B Cash Pay High Yield Index; U.S. Treasuries is represented by Bloomberg U.S. Treasury Index; Bloomberg Aggregate is represented by Bloomberg U.S. Aggregate Bond Index; U.S. Corporates is represented by Bloomberg U.S. Corporate Bond Index and Emerging Markets Debt is represented by JPM EMBI Global Diversified Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. The Sharpe Ratio is a measure of risk-adjusted return, calculated by dividing excess return over the risk-free rate by the investment’s volatility.
Conclusion: Repositioning Fixed Income for a Lower Yield Landscape
As short-term yields begin to decline, the elevated income available in cash today will become harder to sustain. Short-duration, high-yield bonds offer a compelling solution: they provide consistent income potential, with reduced sensitivity to both interest rate and credit risk, thanks in part to their shorter maturity profile and bias toward higher-rated issuers. For investors seeking to transition from cash while maintaining discipline around risk, short duration high yield offers a balanced and effective path forward.
Index Definitions:
The Bloomberg U.S. Aggregate Bond Index is a broad-based benchmark that measures the performance of the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities. Index results assume the reinvestment of all capital gain and dividend distributions. An investment cannot be made directly into an index.
The J.P. Morgan EMBI Global Diversified Index tracks liquid, U.S. Dollar emerging market fixed- and floating-rate debt instruments issued by sovereign and quasi-sovereign entities.
The ICE BofA 1-5 Year BB-B Cash Pay High Yield Index is a fixed income index that tracks the performance of U.S. dollar-denominated, below investment grade corporate debt securities publicly issued in the U.S. domestic market with maturities between 1 and 5 years and rated BB1 through B3.
The Bloomberg US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint but are part of a separate Short Treasury Index.
The Bloomberg US Corporate Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility, and financial issuers.
The ICE BofA US Corporate Index tracks the performance of US dollar denominated investment grade rated corporate debt publicly issued in the US domestic market.
The Bloomberg Global Aggregate Bond Index is a widely used benchmark for measuring the performance of investment-grade, fixed-rate debt from both developed and emerging markets. It includes government, government-related, and corporate bonds, as well as asset-backed and mortgage-backed securities.
Yield to maturity (YTM) is the internal rate of return (IRR) that equates all future cash flows of a bond to its current price. YTM assumes the bond is held until maturity and that an investor can reinvest at the same yield.
About Risk
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value. Index performance is for illustrative purposes only and does not represent actual performance.
Investing in below-investment-grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. High-yield securities (junk bonds) have speculative characteristics and present a greater risk of loss than higher-quality debt securities. These securities can also be subject to greater price volatility.
Bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.
Bond ratings are expressed as letters ranging from AAA, which is the highest grade, to C (“junk bonds”), which is the lowest grade. Different rating services use the same letter grades but use various combinations of upper- and lower-case letters to differentiate themselves. To illustrate the bond ratings and their meaning, we’ll use the Standard & Poor’s format: AAA and AA = high credit-quality investment grade; AA and BBB = medium credit-quality investment grade; BB, B, CCC, CC, C = low credit-quality (non-investment grade), or “junk bonds”; D = bonds in default for non-payment of principal and/or interest.
Treasury Securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity. Interest income on these securities is exempt from state and local taxes.
Diversification cannot assure a profit or protect against loss in a declining market.
Disclosures
Opinions expressed herein are current opinions as of the date appearing in this material only. Investing involves risk, including possible loss of principal. Asset allocation and diversification may not protect against market risk, loss of principal or volatility of returns. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors, and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits.
This material represents an assessment of the market environment as of a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
By subscribing you are consenting to receive personalized online advertisements from New York Life Investments.