Darius McDermott: Is short duration the best bet for bonds?

Darius mcdermott chelsea

For the past three years or more I have been pretty negative on bonds as an asset class. My reason has been the same throughout: interest rates only have one way to go and, when they rise, it could mean capital losses in fixed income.

But I was wrong (or “early” as economists like to say). Instead of rising, rates have fallen further and even gone into negative territory in some cases. The 30-year bond bull run has continued, its life prolonged by accommodative policy from central banks.

Things may finally be about to change, however. Bonds have started to suffer in recent months. Indeed, one fund manager has suggested we could look back in the future and see that October 2016 was when the bubble finally burst.

And every time the Fed has met in the past 12 months, investors have waited with bated breath to see if a second rise would be made. This week the Fed finally took the plunge. On the back of a strengthening labour market, increased inflation expectations and continued expansion in the economy, the committee voted overwhelmingly to increase by 25 basis points. Three further quarter point increases are also likely in the coming year.

In the UK we’ve also seen a pick up in inflation, thanks to big moves in the oil price from its very depressed levels at the start of the year, wage growth and low unemployment. This has been accentuated by the sterling currency shock post-Brexit vote. So real returns from fixed income are being eroded further.

Liquidity is another worry. While most people are worried about it, should investors start to redeem their holdings en masse, it has already had an impact by increasing transaction costs. And then there is continued market volatility caused by the myriad global worries we face today.

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Not great news for investors who need to buy bonds for diversification reasons or for anyone managing portfolios that require them to stay in line with benchmarks. So what to do? ETF flows and new fund launches in the past few months point to a possible answer: short duration bonds.

According to Markit, liquidity investors have been actively de-risking their portfolios since the start of the summer, reducing their long-dated ETF exposure and putting the money into less volatile short-dated treasury ETFs instead.

Active management companies seem to be on the same wave-length, with short-dated corporate bond launches from Aberdeen, Canada Life and Standard Life Investments and others in the past month or so.

Short duration bonds have a number of attributes, all of which help mitigate the risks mentioned above. Most funds of this ilk will invest only in bonds with five years or less to maturity and many are even closer to the end date at the moment. Sensitivity to credit spreads is lessened, as is that to rising government bond yields.

In addition, because the bonds held are maturing, turn-over is low, meaning transaction costs are minimised. The managers are able to reinvest the money into other short dated bonds with higher yields as they come to market.

My preferred fund in this space is one that has been around since 2010: Elite Rated Axa Sterling Credit Short Duration Bond, managed by Nicolas Trindade. Around a fifth of his portfolio matures every year, so you can see how easy it could be for him to put this money to work very effectively, if we are indeed heading towards the end of the credit cycle.

There are downsides, of course. The yield on these bonds is very low (although still better than the base rate) and, if I’m still too early in my predictions, and bonds live to fight another day, investors could miss out on a continued rally. Time – short or long – will tell.

Darius McDermott is managing director of Chelsea Financial Services and FundCalibre.