DEC 7

Keeping it short and sweet

Julia Faurschou, Investment reporter for Investment Adviser

How are investment professionals positioning portfolios to counteract inflationary forces and mitigate risk? Julia Faurschou reports.

Investment professionals have slashed duration in fixed income portfolios over growing concerns surrounding rising interest rates and instability in global bond markets.

The move to short duration strategies is meant to provide protection against rising interest rates and ongoing volatility in the fixed income market, which has compounded the downside risk on bonds.

Bond yields have fallen dramatically in recent years due to a combination of unusual central bank policy, slow growth and little inflation. Low interest rates have lessened the appeal of holding cash and intensified the search for yield, pushing many investors into higher risk assets in order to access income.

Ian Spreadbury, portfolio manager at Fidelity International, says investors are right to be considering the risks to their fixed income portfolios at this point in the credit cycle. He warns investors to be mindful of interest rate sensitivity in portfolios with the prospect of inflation and interest rate rises on the horizon.

“Eight years into this extended credit cycle, deteriorating credit quality and rising corporate leverage are causing further headaches to investors who need income. Against this backdrop, short dated corporate bonds represent only a modest extension of interest rate risk and credit risk,” Mr Spreadbury comments.

Fidelity recently launched the Short Dated Corporate Bond fund, managed by Mr Spreadbury and Sajiv Vaid, in order to keep up with investor demand for a fund that delivers capital growth in a low risk manner. The fund focuses on investment grade corporate bonds that are sterling denominated or hedged back to sterling, with a maturity of no more than five years.

“Short dated credit is an ideal solution for investors who desire a modestly higher yield and risk profile than cash and government bonds, but who consider a conventional corporate bond fund a step too far,” Mr Spreadbury says.

“Short dated corporate bonds exhibit lower drawdown and volatility than their all-maturity counterparts, and their short nature ensures that bonds will be naturally maturing whilst in the portfolio, providing sufficient liquidity.”

Politics

Political events have had a substantial impact this year on global fixed income market, and this trend is likely to continue in 2017. The surprise outcome from the US presidential election triggered a sharp rise in government bond yields globally.

Donald Trump’s presidency could lead to more fiscal spending, which could ultimately boost inflation, growth and bond yields.

Volatility in global bond markets driven by uncertainty in the US could be compounded by the Italian constitutional referendum, whether the ECB extends its quantitative easing programme further, and next year’s elections in the Netherlands, France and Germany. All could have a dramatic effect on government bond yields.

Nicholas Trindade, manager of the Axa Sterling Credit Short Duration Bond fund, believes these events could make it more difficult for the Bank of England to act as an “efficient backstop” in the future.

This inefficiency of the central bank policy has been magnified by the fact that the bank have already bought one third of the £10bn worth of corporate bonds it intended to in just either weeks when the programme was meant to last 18 months.

“In an environment where we expect volatility to remain high, short duration strategies provide a compelling solution for investors as they’ve been able to efficiently minimise volatility and drawdowns in some of the most testing financial markets seen in recent years.

“More specifically in our AXA Sterling Credit Short Duration Bond fund, we are currently focusing on low beta sectors as we are keen to maintain a defensive bias within the Fund to potentially benefit of pockets of weaknesses ahead,” Mr Trindade says.

Interest Rates

Speculation that interest rates could rise in developed markets in the coming months has prompted many managers to cut duration in their funds as a way to take advantage of interest rate movements.

Anthony Rayner, manager of Miton’s multi-asset fund range, says he has shortened duration in the portfolio as a way to reduce interest rate risk by buying short dated, good quality corporate bonds where “we’ll receive the yield but with much lower risk of capital loss”.

He says while many of those forces, such as rising debt and changing demographics, that have driven bond yields lower over the last few decades are still intact, bond markets continue to suffer and yields creep higher.

“We don’t forecast markets and the pace of change might not be repeated but we do think there has been a sea-change in the dynamics driving bond markets, and possibly financial markets more generally.”

Fixed interest markets are already beginning to exhibit increased volatility as the market looks ahead to a higher rate environment, which naturally leads investors to position in the most appropriate part of the market, according to AJ Bell’s head of fund selection Ryan Hughes.

“Given the lower level of sensitivity to interest rate changes, this currently makes short duration bonds look attractive as a way of insolating from the worst of the volatility, albeit it should be remembered that even short duration bonds will not be totally immune to this volatility.

“For those investors who need to have fixed interest exposure, having some of this exposed to shorter duration strategies would naturally make sense at this uncertain times,” Mr Hughes adds.

While the most common way managers cut duration to by investing exclusively in bonds that have a short time to maturity, it is also possible to use derivatives to shorten the duration of a portfolio of otherwise long duration bonds, explains Kasim Zafar, portfolio manager at EQ Investors.

He adds: “Less obvious is to find assets that carry no duration risk at all, such as floating rate notes. Asset backed securities are one example of bonds in this space.

“Each short duration strategy carries its own set of unique risks. Therefore, we believe the best strategy is to diversify across them, based on availability of investment products and ability to invest in each.”