Short duration bonds often have a role to play in an investor’s portfolio regardless of the market cycle – but their appeal today is stronger than ever, according to AXA Investment Managers.
Bruno Bamberger, Co-Head Investment Specialists, Fixed Income at AXA IM, says the current macroeconomic backdrop – with increased uncertainty over economic growth, inflation, interest rates and borrowing costs – gives investors more reasons than ever to consider short duration strategies.
While we have seen a steepening of yield curves since the lows in 2023, the current steepness is well below historical averages. This, and the outright level of yields, makes fixed income an attractive asset class. This is especially true for short duration, where investors can find similar yield levels to longer duration bonds but with potentially less interest rate risk. Expansionary fiscal policies across the globe, coupled with geopolitical risks and trade wars could lead to higher long-term interest rates, while on the other hand, central banks accommodative monetary policies could benefit to shorter term rates, leading to a further steepening of the yield curve. This would favour investors positioned at the shorter end of the curve.
“With opportunities across fixed income, particularly credit, short duration potentially presents a route that may provide attractive total returns while mitigating interest rate risk,” he says. “Yet short duration is not one homogenous asset class and, as such, offers a range of outcomes for different investor needs.”
One option for investors looking to enhance cash returns is to take an intermediate step into riskier assets via the short duration part of the curve.
“Central bank rates are still expected to fall and as such cash is no longer king and therefore high quality short duration strategies, with their typical maturities of up to three or five years, should offer a suitable bridge between cash holdings and longer-term fixed income investments.”
Investment grade, short duration Euro credit strategies could hit the sweet spot between enhancing the yield over cash rates, by benefitting from increased government stimulus which should support credit assets, while limiting the impact from government increased debt issuance putting pressure on longer-term yields.
Bamberger believes short duration strategies could also act as a tool to generate positive total returns in an uncertain environment.
“Short duration bonds within asset classes such as high yield or emerging markets may therefore be an option to help investors access higher income and growth while still mitigating against interest rate risk,” he says.
“This is particularly the case for US high yield short duration strategies, which should benefit as the high positive carry of the asset class helps to offset any drawdowns, while benefitting from the ongoing resilience and pro-growth strategy of the US economy keeping a lid on credit spreads.”
As the most liquid part of the US high yield market, Bamberger believes this could offer investors higher liquidity as well complementing other asset classes.
While the benefits of core short duration strategies such as investment grade credit and high yield bonds are clear, he believes there remains an often-overlooked group of strategies for investors seeking upside in returns.
Bamberger highlights Inflation-linked bonds (ILBs) as an example of a type of bond that tends to have a lower correlation to other fixed income asset classes or stocks.
“This is because the coupons and principal payments of an ILB increase with inflation, contrasting to other asset classes where the value decreases when inflation rises,” he says. “Short duration inflation-linked bonds could provide an effective hedge against inflation, low exposure to interest rate volatility, and a low correlation to other fixed income assets.”
In periods of uncertainty and greater volatility, moving dynamically across regions, sectors and asset classes may help provide investors with opportunities, he adds.
For Bamberger, the need for European countries to raise defence spending in the wake of US threats to withdraw some of its overseas security spending could be hugely significant for fixed income markets.
“German government bond yields rose sharply following the German government’s announcement that it would seek to boost spending, and we expect a rise in long-term real interest rates and in the neutral interest rate,” he says.
A higher global long-term interest rate should, he argues, reprice fixed income, with European bond yields moving higher. That may prompt investors to consider short-duration fixed income assets, particularly in their own currency, as these bonds are less volatile.
He adds: “With Trump’s presidency creating potential headwinds beyond the US, continuing geopolitical challenges across the Middle East and Ukraine and the expected divergence in central bank’s monetary policies, many investors may look to a flexible approach as it provides the potential to exploit opportunities available in the global short-dated fixed income universe via active asset class and sector allocation as well as active management of duration across currencies.
“Short duration offers portfolio managers a cheap and easy way to implement active views through the natural liquidity pipeline from bonds maturing.”
By Bruno Bamberger, Co-Head Investment Specialists, Fixed Income at AXA IM
