(Bloomberg) BlackRock Is Buying the Bonds Most at Risk From Added Fed Hikes

Two-year Treasuries yield about 1.8 percent, rising from 1.25 percent just three months ago. As a result, the extra yield that investors get by extending to 10-year notes shrank to as little as 50 basis points last week, the smallest spread since 2007. The curve flattening makes sense — the Federal Reserve is set to raise rates this week and projects more hikes in 2018. The two-year note is the most sensitive coupon maturity to central-bank policy.

Bond traders have already built in a buffer against further tightening, with the two-year yield more than 60 basis points above the effective fed funds rate.

Granted, if the Fed sticks to its projected path of three more hikes in 2018, short-term yields will climb even higher. But Colin Robertson at Northern Trust Asset Management only sees one 2018 hike. And for Rieder, who expects three, the value is still there, given that the investor would only hold the debt for a couple of years.

“We like the front end of the curve — you carry really well in the front end for two years, three years,” Rieder, global chief investment officer for fixed-income at BlackRock, said in a Bloomberg Television interview Friday.

For all the talk about international buyers swooping in to buy long-term Treasuries and compressing the yield curve, the difference in yield on short-dated securities across countries is pretty stark too.

Investors pick up an extra 253 basis points from owning two-year Treasuries rather than their German counterparts. That’s the most since 1999.

And it wasn’t that long ago that the yield now available on the two-year U.S. maturity was the best one could hope for on a 10-year note. Four days before the 2016 American presidential election, the 10-year yield closed at 1.78 percent.

“To me, two years at 1.8 percent look very attractive,” Robertson, head of fixed income at Northern Trust Asset, said in an interview. Traders are mistaken if they’re anticipating “a lot of moves from the Fed.”

Neither Rieder nor Robertson see the yield curve inverting next year, unlike a growing chorus of Wall Street fixed-income strategists. Rieder says that’s because inflation will pick up and the 10-year yield will gradually rise to 2.5 percent or 2.75 percent. Robertson’s view is that the Fed won’t want to drive the curve toward zero, and will therefore slow its rate hikes.

Either way, the notion that the short end offers good value will serve as the bond market’s backdrop to this week’s Fed decision.