Bonds: the shorter the better

The growing alarm about inflation is an argument for investing in short-term bonds.
Raymond Sagayam

Equity Partner & Chief Investment Officer - Fixed Income

Pictet AM

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Supply bottlenecks multiply as households and businesses with high levels of cash may be willing to accept higher prices.  Add to this is a shortage of labour and rising wages.  In fact, inflation expectations, due to the difference between the nominal yield to maturity at a fixed rate and that of inflation-linked in ten years US debt, has reached maximum of eight years. 

In this state of affairs, with the increase in yields to maturity, investment in sovereign bonds in the US, united Kingdom and euro zone, as well as emerging markets credit, has meant losses the last twelve months. While it is far from clear whether inflation will be temporary, if it takes hold most risk asset classes will suffer and the real value of cash will erode.

A knee-jerk reaction is to reduce bond exposure.

However, whatever happens with inflation and despite the macroeconomic and financial markets turbulences in coming months, short-term bonds offer the possibility of isolating from this volatility, without sacrificing return. It is an asset class largely overlooked the past five or six years, during which time most investors have been attracted by risky assets and higher-yield to maturity debt.

But short-duration bonds are much less sensitive to changes in interest rates than those with a longer maturity, in a range not seen in ten years.  This reflects that corporate and sovereign borrowers have taken advantage of the low interest rates to issue longer-term debt.  In global corporate debt, the effective duration is currently 7.4 years, compared to 1.9 years in the short term, having increased two years in a decade.  Our tests of resistance to a steepening of sovereign debt yield to maturity curve, which estimates its effect on bond prices, shows that our short-term strategies are between 25 and 56% more resilient.  For example, a 1% increase in interest rates would cause high-yield US debt to go into investment losses, but they would have to increase 2.4% for losses in short term high-yield debt.

Under normal circumstances reducing duration means sacrificing profitability at maturity, but this is not so much the case. The US high-yield debt yield to worse -taking into account possible repayments before maturity- average 4.17% with 4.2 years duration. In the short term 3.44% with 2.7 years duration.  The situation is similar in Europe and investment-grade asset class.

In addition, short-term bond funds offer a healthy degree of diversification: there are more than 1,300 issuers in global short-term credit, similar in all short-term bond markets. In addition, the short-term credit universe has a wide range of high-quality investment-grade borrowers, with one-year maturity debt offering higher spreads to five year ones.

Even investors who wish to minimize risk can consider money market funds, with an average weighted maturity of less than one year and ultra-short duration.

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Bonds: the shorter the better