Over the past few years, and more than ever this year, markets have been rapidly switching between risk-on and risk-off, bull and bear markets. With volatility generally expected to remain heightened, investors could consider different ways to prepare their portfolios for shifting markets.
A strategic allocation to the AXA Sterling Credit Short Duration Bond Fund could be a potential option for investors, as this strategy displays markedly lower volatility than the all maturities sterling credit market, and aims to provide consistent, incremental returns in excess of cash.
How do short duration bonds perform in different market conditions?
Typically a short duration bond fund outperforms the wider, all maturities market, in an environment of rising government bond yields. This is not only due to the lower duration (hence lower sensitivity to changes in bond yields), but also to the attractive maturity profile, as the cashflows from frequently maturing bonds can be regularly reinvested at higher yields in the market. A short duration bond fund also exhibits a lower sensitivity to changes in credit spreads, and as such will typically outperform in an environment when credit spreads widen. Therefore, short duration investing offers limited volatility and drawdowns when compared to the broader markets.
Conversely, short duration bonds typically underperform their reference, all maturities credit market, in an environment where credit spreads tighten or government bond yields fall. As such, short duration bonds will benefit less from such an environment, when compared to the broader markets.
What is the most efficient method of implementing short duration?
There are two common methodologies for fund managers to build a short duration portfolio.
One way, which is our chosen methodology within the AXA Sterling Credit Short Duration Bond Fund, is to invest directly in short-dated corporate bonds. This means that the duration of the fund is a direct result of the bonds that have been bought.
Another way is to invest across the maturity spectrum, and to use derivatives to artificially decrease the duration of the portfolio. We believe the latter approach is sub-optimal for two main reasons:
• Firstly, as the underlying bonds mature farther out in the future, even if the interest rate risk is reduced through derivatives, the credit spread risk may still be high - which can ultimately have a negative impact on risk-adjusted returns. Furthermore, investing directly into shorter-dated bonds allows us to have an even more accurate view of a company's fundamentals and ultimately its ability to repay its debt.
• Secondly, and most importantly, these funds do not benefit from an attractive natural liquidity profile (with 20% on average maturing each year in the case of our fund), as many of their underlying bonds will mature much farther out into the future. This will diminish their ability to naturally minimise transaction costs and benefit from a rising yield environment, and they will not benefit from having access to an additional liquidity buffer.
Conclusion
The recent rally in core government bonds has led to a flatter yield curve, meaning the difference between the longer-dated and shorter-dated yields are lower. As such, the cost of reducing duration, in terms of yield given-up, is the lowest it has been for some time.
Therefore, in an environment where the BoE is most likely to cut rates during the summer and volatility to remain high, the incentive to invest directly in short duration bonds is ever more compelling.
Nicolas Trindade
Fund Manager, AXA IM
Nicolas Trindade manages the AXA Sterling Credit Short Duration Bond Fund. He joined AXA IM in July 2006 and is a Senior Portfolio Manager within the Sterling Credit team, managing approximately £1.2bn in assets.
In addition to his portfolio management responsibilities, Nicolas leads the Sterling Credit "Alpha Group".
Prior to his appointment within the investment team in June 2010, he spent nearly three years within the Fixed Income Product Specialist Unit, where he was responsible for the development of our UK, US & High Yield product ranges.
Nicolas holds an MSc in diplomacy and international strategy from the LSE as well as a Master's degree in IT engineering from Telecom SudParis (France) and is a CFA Charterholder. Nicolas Trindade manages the AXA Sterling Credit Short Duration Bond Fund.
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