Article
Short duration corporate bonds to manage portfolio risks
Short duration credit bonds lower a portfolio’s sensitivity to changes in interest rates and credit spread movements.
November 8, 2022
It has been a tough year for bonds. The Bloomberg Global Aggregate Total Return Index dropped below 20% from its previous peak, delivering the worst year-to-date performance since inception.
There is, however, one problem: this is the wrong way to look at bonds. We believe that bonds should never be lumped together and viewed in aggregate, as a single asset class. Such a headline means nothing to active bond investors.
This is because fixed income is vast. There are many different types of bonds, and each is exposed to diverse risks with various levels of concentration. This makes fixed income incredibly useful when it comes to risk management.
If used properly, bonds can be deployed to manage portfolio risk with a high degree of precision, in pretty much any investment environment. This holds true even now, in current conditions. Short duration corporate bonds are a good example of this. To understand why, we need to talk about inflation.
Inflation raises risks for fixed income investments
This topic dominates investment headlines worldwide. Many countries in the Bloomberg Global Aggregate Bond Index are experiencing their highest levels of inflation in nearly four decades. As a consequence, central banks have been raising interest rates in an attempt to tame rising inflation.
In fixed income, changes in interest rates are considered a risk which, among other factors, is captured by a concept called duration. Duration measures how long it takes in years for an investor to be paid back the price of a bond using that bond’s total cashflows. Duration also captures the sensitivity of a bond’s price to a change in interest rates. As such, we believe that the solution is to invest in bonds that offer a lower level of duration and have, in turn, lower interest rate sensitivity.
This brings us to short duration bonds and their many attractive features.
Short duration corporate bonds are a great solution
Alongside inflation, bond investors are facing numerous challenges in today’s investment environment. Markets across the board have been volatile. Luckily, short duration corporate bonds from investment grade issuers lower both a portfolio’s sensitivity to changes in interest rates and credit spread movements.
These types of bonds also offer less exposure to credit risk compared to other short duration securities such as high yield bonds. They offer better credit quality to bondholders, meaning that they are exposed to less default and liquidity risk.
If investors focus on security selection among investment grade issuers, they can effectively manage and minimize their exposure to default risk. Meanwhile, they can use the regular cashflows from those bonds close to maturity in order to achieve lower transaction costs and higher re-investment rates (in a rising yield environment), while helping avoid a forced selling scenario. Overall, a short duration corporate bond strategy can help investors improve their liquidity profile.
There are also other advantages to these bonds. Together with their predictable income, they can potentially provide investors with a stronger return than they would otherwise achieve with a money market fund, by offering a more attractive yield.
Short duration bonds benefit from flattening yield curve
The yield curve is flattening across Europe and North America, which benefits short duration bonds. To understand why, we need to first understand what a yield curve is and why bond investors pay attention to it.
The yield curve is a line that plots the yields of similar credit quality bonds with different maturity dates. It is typically upward-sloping: the longer the maturity, the higher the yield on offer because there is more exposure to inflation and default risks.
However, this is not always the case. The yield curve can also flatten or even become inverted if investors are worried about the economy slowing down. Right now, yield curves are flattening because central banks are raising interest rates and the market is pricing in recessionary risk. Therefore, corporate bonds with short, one-to-three-year maturities presently have a yield in many countries that is only slightly lower than that on the broad market, which comprises bonds of all maturity lengths.
The Bloomberg Global Aggregate Credit Index currently offers interest rates that are just 44 basis points higher than those in the one-to-three-year global corporate bond segment. Over the last decade, the average return on investment was over one percent. This means that there is no longer a reward for having bonds at the long end of the yield curve and being exposed to higher interest rate sensitivity and volatility.
Historical development of the rate of decline in global short-term corporate bonds against the overall market as a percentage
General risks
- Potential loss: investors may lose part or all of their investment.
- Market risk: market conditions can trigger fluctuations in total returns.
- Liquidity risk: some investments may entail liquidity risk.
- Foreign currency risk: a given investment’s total value can be adversely affected by exchange rate fluctuations.
Don’t be short of short duration
This is a moment in time when investors should not be short of short duration bonds from investment grade issuers. These bonds offer lower sensitivity to rising interest rates while also providing a yield pick-up over money market funds. They are also less exposed to default and liquidity risk compared to high-yield and medium or longer dated bonds.
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