Short duration bonds to the rescue?

  • Already low yields have collapsed further this year as central banks act to support the global economy
  • Investors looking for an alternative to cash may think they have few options, but short duration bonds could prove attractive
  • Short duration bonds still offer positive real returns in many markets, allowing investors to beat both inflation and negative rates while also minimising volatility and drawdowns

Coming into 2020, interest rates in much of the world were already low by historical standards. With the Covid-19 pandemic forcing central banks to ease policy further this year, savers will struggle to achieve a yield much above zero on cash in the bank. When taking inflation into account, cash becomes loss-making as even a low inflation rate – as long as it is higher than interest rates – can erode the value of savings over time.

With central banks seeming unlikely to raise rates over the near or even medium term, investors now urgently need to look further up the risk spectrum when it comes to their cash allocations.

What short duration offers in a low rate environment

Fortunately, there are alternatives. In my view, short duration bonds are the next step up for investors using cash as a strategic asset. It might sound counterintuitive to use short duration bonds when their protection against rising interest rates might not be needed, but their lower volatility compared to longer duration credit is still an important consideration with interest rates and yields are low or negative. Importantly, actively managed short duration bonds portfolio could provide a real return even when accounting for inflation.

While short duration bonds can still fall in value during market downturns, the nature of the asset class means that drawdowns tend to be short lived.

It is not just your average person in the street who may be looking towards short duration funds. Companies have raised huge sums of cash to help see them through the pandemic; they will not want to see it eroded by inflation, merely becoming a loss-making asset on their balance sheets. Short duration bonds can help them to avoid this.

Rates could go lower still

Central banks might even give investors another push towards short duration bonds if they take rates negative – or further into negative territory for the European Central Bank. This seems unlikely in the US, where the Chairman of the Federal Reserve, Jerome Powell, recently stated that negative rates were ‘not a tool…that we’re looking to use.’

It seems more plausible in the UK though, where Gilts are already negatively yielding out to six years. The Bank of England (BOE) recently wrote to major UK banks asking how prepared they were for negative rates, although there are questions around whether the BOE would really follow through.

Read more: Why short duration Asian bonds could be a flexible and well-timed play on market uncertainty?

Outlook

Markets are likely to be volatile in the near term. The natural reaction for many will be to go to the perceived ‘safety’ of cash, but there are alternatives to locking-in losses by holding that asset class.

In a low yield environment, short duration can offer a relatively conservative route to accessing diverse opportunities across the fixed income spectrum, including high yield.

Furthermore, in volatile conditions, short duration assets are naturally less sensitive to sell-offs and tend to recover quickly from any drawdowns. The short-term nature of the asset class provides the potential for cash to be returned relatively quickly. Hence we believe individuals and companies may find the prospect of putting cash to work in generating a bit more yield for a bit more risk more attractive than having it sit in the bank.

For those reasons, we think short duration bonds provide an attractive alternative to cash, even if they might seem an unlikely hero at first glance.