Core vs. Intermediate Government/Credit: Which to Choose?

October 05, 2016

Our Chart of the Week examines the relative performance of Core and Intermediate Government/Credit fixed income strategies in rising and falling rate environments. The chart shows Core’s annual total return since the 1970s as represented in the blue using the Barclays U.S. Aggregate index. Annual total return of the Barclays Intermediate Government/Credit index is shown in orange. We also include inflation in green, using the CPI’s annual change, and the 10-year Treasury yield in gray. As one can see, Core beat Intermediate Government/Credit and inflation when rates dropped during the 30-year bull run for bonds from the 1980s to today. This is because Core features higher yields and longer duration, the latter of which boosts bond prices when rates drop. But Core lags Intermediate Government/Credit and inflation if rates rise significantly, as we experienced during the 1970s oil crisis. This was again because of Core’s longer duration. In other words, Core’s longer-dated bonds took much longer to be recycled out as rates rose and newer, higher-yielding bonds came to market; as a result, returns lagged.

Going forward, no one knows whether rates will go up or down. We performed projections based on the likely scenario that the Fed hikes 25bp per year for the next three years. We assume a flattening curve and the 10-year Treasury rises 10bp per year. In this scenario, we estimate that Core will beat Intermediate Government/Credit because of its higher yield despite its longer duration. If the economy gets worse, we assume there are no hikes and the 10-year Treasury yield goes to zero in three years. For this case, we estimate that Core will beat Intermediate Government/Credit handily because of both its duration and yield pickup. What it takes for Intermediate Government/Credit to beat Core is extremely strong economic growth or a dramatic inflationary environment where prices of goods skyrocket, during which we assume 0.5% or more of annual increases in the 10-year Treasury yield. Here, Core’s longer duration hurts it more than its higher yield. These estimates do not account for technical market selloffs or buying binges, but show what a perfectly rational market is expected to do.

As a practical takeaway, if investors are deciding between Core vs. Intermediate Government/Credit, this shows that Core is more resilient in the more likely scenarios. On the other hand, if an investor has chosen Intermediate Government/Credit for its lower duration, its performance will be relatively similar to that of Core in all scenarios. Ultimately, both strategies will provide liquidity, diversification, and safety in the event of market stress; relative performance across interest rate environments will not be significant, though core offers a bit higher upside under the most likely interest rate scenario over the next few years.