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14 September 2016

Bonds not built to last: short duration

By James Yardley, Senior research analyst

Most government bonds no longer offer any income to speak of and some are even guaranteed to lose you money. Richard Woolnough, manager of M&G's Elite Rated Corporate Bond, Strategic Corporate Bond and Optimal Income funds, made headlines in The Times today, paraphrased as telling investors that “cash under the bed has become better than bonds”.

While this is simplifying the issues somewhat, Richard's key point that the advantages of government bonds over cash—particularly when viewed in the light of 'safe haven' assets—are gone is one that I've also been making for some time now.

The solution for those still wanting a fixed interest allocation could be to either increase their risk and invest in higher yield corporate bonds, or to invest in bonds that have a shorter life span, known as 'short duration bonds'.

What is a short duration bond?

A short duration bond is a bond with a short time to maturity. AXA Investment Managers, who run the Elite Rated AXA Sterling Credit Short Duration Bond fund, define this period as up to five years within the sterling market and typically up to three years within the US or European markets.

The AXA Sterling Credit Short Duration Bond fund currently holds 82% of its portfolio in sterling corporate bonds and 13% in non sterling corporate bonds. It has a 4% weighting to cash and just 1% in sterling government bonds¹.

Why shorter is better right now

It may feel like interest rates will never rise again, but eventually they must. Think about the fact that many bonds are issued for periods of up to 30 years – surely we'll see interest rate rises before 2046!

When rates do go up, bonds yields will follow suit. This will mean bonds issued after that point will be paying a higher yield than bonds already in the market. So these older bonds become less valuable.

Another risk for bonds is inflation. Rising inflation is very bad news for bonds (unless they are inflation-linked), as it means the flat rate of return they offer is essentially worth less in real terms.

The thing is, no-one can guess when these rate rises might happen or which way inflation will move. So buying any bonds with distant maturity dates exposes you to these risks. Bonds with short-term maturity dates, however, are less sensitive to these factors.

More mature

Short duration bonds are naturally more liquid than their long-dated cousins. In a rising yield environment this is a particular advantage, as it means the cash flows from frequently maturing bonds can be regularly re-invested at higher yields in the market. As I've already mentioned above, at some point yields will start to move in this direction. With a potential US rate rise on the cards, this could be sooner than we think.

In the meantime, however, short duration bonds in a fund also bring the benefit of lower transaction costs. Turnover can be minimised because bonds naturally reach maturity and pay out, meaning there's less need to 'trade' holdings.

Better than cash, but won't shoot the lights out

For cautious investors, short duration bonds offer the potential to at least deliver a more attractive return than cash at the moment. It's true they can't magic yield out of nowhere, and so at the end of the day you're still looking at a fairly low level of income, but given the current climate, investors must be reasonable with their expectations.

The key goal of short duration should be to minimise risk and smooth out the impacts of market volatility, not to be the fastest growers in your portfolio. In a 'normal' environment where yields are rising, you get a lower yield on your short duration bonds than on your long – this is the trade off for taking less risk. It is this lower interest rate risk that makes the short duration bonds less volatile.

Of course it's important to remember short duration bonds are not entirely risk-free and there is still the chance that you could lose money by investing in them or any funds holding these assets.

Our research note on the AXA Sterling Credit Short Duration Bond fund

Where to next?

¹AXA Sterling Credit Short Duration Bond factsheet, AXA Investment Managers, 29 July 2016

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. James' views are his own and do not constitute financial advice.

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