By James Ringer, Fixed Income Portfolio Manager, and Karen Wright, Associate Investment Director Global Unconstrained Fixed Income, at Schroders
Turning to cash may seem tempting but waiting comes at a cost unless you’re being paid. Short-dated bonds present an attractive alternative.
The war in the Middle East has introduced a new level of uncertainty to the global outlook and it’s understandable that investors might turn to cash as a default “wait-and-see” approach. It’s true, parking in cash can reduce portfolio volatility, but it doesn’t eliminate risk. In fact, short-dated bonds (those with maturities of five years or less) can offer a more effective way to preserve capital, as well as generate income and return, making them particularly attractive in periods of uncertainty.
When central banks cut interest rates, cash rates respond instantaneously, exposing cash allocations to reinvestment risk. Short-dated bonds in comparison effectively lock in the attractive yields for longer and they continue to pay a fixed level of income regardless of what’s going on geopolitically.
As a starting point, short-dated bonds today are yielding significantly higher than cash deposits. This means that they also have the ability to generate returns in excess of inflation, which is something cash rates are struggling to achieve.
The income element of short-dated bonds does much of the heavy lifting here, but it’s the opportunity to combine historically high yields with a low level of interest rate risk that provides a sweet spot between “risk” and “return”.
What this provides is a substantial cushion to capital losses. This is because bonds pay regular fixed coupons, regardless of global influences, while duration (or sensitivity to interest rates) is lower because a bond’s payments (coupon and principal) are repaid faster compared to longer dated bonds, (increasing clarity on the monetary policy outlook). Put simply, as bonds approach maturity, certainty increases.
With some investors drawing parallels with the outbreak of the Russia / Ukraine war back in 2022, it’s this income element which really makes a difference this time around, as the chart below shows.
Aggregate indices with a 1 – 3 year maturity: breakeven levels – the amount yields need to rise before incurring losses
\nWhile the shape of yield curves have fluctuated since the outbreak of the war in the Middle East, the upward sloping characteristic means that short-dated bonds offer not just attractive levels of carry (income earned from holding bonds) but roll down too. Roll down, as the name suggests, is when the bond “rolls” to a shorter maturity (say, from five years to four) where yields are typically lower, which mechanically raises the \u200b price.
In comparison to today, yields in 2022 were much lower – negative in some cases – and yield curves were much flatter. \u200b The chart below illustrates the additional return which can be made through carry and roll in short-dated European rates markets.
A “return to normality”: attractive carry and roll down
\nThis structural benefit today contributes to the relative stability of short-dated bonds (compared to longer maturities) as well as the potential to generate higher risk adjusted returns versus cash.
Given the structural nature of short-dated bonds described above, an allocation does not require perfect timing: income is earned regardless of the market’s focus, whether that’s war, labour markets, fiscal policy, or something else.
However, the yield levels of short-dated bonds are currently clearly enticing and, importantly, it’s not necessary to ramp up the level of credit risk to achieve these attractive levels. Instead, investors are able to choose from a range of options to gain active exposure – from short dated aggregate solutions (a mix of credit and government bonds) to more unconstrained strategies, which tend to have greater exposure to high yield corporates.
Of course, active fund strategies have the ability to enhance yield over their benchmarks too, adding an additional layer of stability and return. Whatever an investor’s risk profile, short-dated bond yields are attractive, making holding cash an opportunity cost.
Granted, market uncertainty persists – headlines swing daily and markets can be very sentiment-driven against this backdrop. However, waiting for clarity can often mean missing out on the best opportunity, as front-end yields will have already moved by then. It’s that fall in yield that can provide that additional kicker to short-dated bond returns.
The market’s recent focus on the war’s inflationary impact from rising energy prices has driven markets to price in interest rate hikes across bond markets. The chart below shows that government bonds are pricing in a number of rate hikes, with the eurozone for example currently reflecting expectations of three rate hikes for \u200b the year – having previously priced in rate cuts. However, many of these hikes are unlikely to be realised.
A resolution to the conflict and some macro clarity have the ability reverse these moves. Market narratives shift quickly and one that shifts from focusing on inflation to one focusing on demand destruction and an easing of monetary policy conditions has the potential to generate substantial capital gains. This scenario would be a clear positive for short-dated bonds, while cash rates would simply fall in comparison.
Benefiting from capital gains if hikes are priced out
\nIn this environment, investors’ caution is understandable but the choice for bond investors isn’t as binary as being highly exposed to duration risk or retreating into cash. Short-dated bonds sit between the two –the potential to generate high risk adjusted returns provides a practical alternative for uncertain times.
Certainty rarely arrives all at once. While short-dated bonds are not particularly exciting – what they do offer is stability of income and resilience. Sometimes being paid to wait is the most rational approach of all.
Further reading : click here