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Short Duration: Picking up yield and minimising risk in an uncertain world

  • 28 July 2020 (10 min read)

Key points

  • At the height of the market crisis in March, we saw a highly unusual ‘bear flattening’ of the credit curve
  • While credit markets have largely recovered since then, the yield curve is still flatter than it was pre-COVID-19, providing an attractive entry point for investing in short-dated bonds
  • We believe pockets of value remain and short duration approaches offer the potential to enhance risk-adjusted returns in this uncertain environment

An unprecedented period for fixed income

When COVID-19 took hold of global markets in March, fixed income investors were dealt a blow, with the sterling corporate bond market experiencing its worst ever monthly excess and total returns (-7.86% and -6.95% respectively) – an even bigger decline than at the peak of the global financial crisis in 2008.

The short-end suffered particularly badly, with credit spreads widening significantly more than at the long-end. The result - a ‘bear flattening’ of the credit curve - meant the short-dated bond market suddenly yielded investors as much as the all-maturities market – an unusual scenario, given that credit curves are usually upward sloping. A few factors have contributed to this, including the fact that the market started to price in an irrationally large number of defaults/impairments in March, and a negative technical as short-dated bonds were sold before longer-dated bonds in order to raise liquidity (short-dated bonds are generally more liquid and therefore easier to sell).

While credit markets have largely recovered since then, resulting in the shortest bear market ever in credit markets, the yield curve has not reverted to its former state – it is still flatter than it was pre-COVID-19, meaning that today is still an attractive entry point for investing in short-dated bonds.

What’s changed?

New issuance
In recent months, we have seen record levels of new issuance across the board, but particularly in US dollars and euros. Sterling issuance has remained underwhelming so far, as lots of issuers (including UK ones) decided to issue in euros and US dollars to benefit from more liquid markets and lower funding costs.

Improved liquidity
Liquidity dried up somewhat at the start of the pandemic, but even in March we didn’t see the lows reached in 2008. The help of central banks has been key in supporting markets; the Bank of England, European Central Bank and US Federal Reserve have all been very active in buying corporate bonds, resulting in a significant improvement in liquidity in recent months.

Fallen angels
In the near future, it is likely that we will continue to see a larger-than-usual number of ‘fallen angels’ in the credit markets, as some of the weaker BBB rated names are downgraded to BB and therefore classified as high yield.

However, given the severity of the pandemic, the level of fallen angels thus far has been lower than expected, thanks to the unprecedented support from central banks and governments worldwide; and those that have occurred have been relatively efficiently absorbed by markets.

Outlook for short-dated bonds

The reality of COVID-19 is that we cannot say whether we are over the worst or on the brink of a second wave. Moreover, all advanced economies are forecast to be in recession this year. Yet markets have been so heavily propped up by monetary and fiscal support that they barely reflect this.

With the outlook remaining so uncertain and valuations having recovered a long way, we are not taking a blanket approach to adding beta risk, but rather focusing on specific pockets of value that have lagged the recovery thus far. For example, within investment grade, we focus on companies with robust balance sheets that are in cyclical sectors currently out of favour and, as such, have missed out on the recent recovery.

In summary, while it is true that spreads have tightened significantly since their March highs, the flatness of the curve provides an attractive entry point to buy short-dated bonds. This, combined with our ongoing search for pockets of value, can help investors enhance their risk-adjusted returns in this uncertain environment.

AXA IM’s short duration bond strategies

AXA Investment Managers offers a range of short duration strategies that aim to provide a variety of outcomes.

Our short duration strategies generally invest in bonds with maturities of five years or less and seek to capture high current income with low overall volatility. The result will be portfolios with a duration that is generally below three years.

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