Bonds not built to last: short duration

Most government bonds offer very little in the way of income right now. Richard Woolnough, manager of M&G’s Elite Rated Corporate Bond, Strategic Corporate Bond and Optimal Income funds, made headlines in The Times in September 2016, 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.

The solution for those still wanting a fixed interest allocation could be to either increase their risk and invest in higher yielding 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.

Why shorter is better right now

When interest rates go up, bonds yields follow suit. This means newly issued bonds 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, it is very difficult to guess when 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.

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.