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The short and long of bond investing

Bonds

The market is changing

Opportunities for significant capital returns may have receded, but bonds remain vital to balancing risk and return. Investors will be paying closer attention to the duration of their bond portfolios as they review the logic for holding fixed interest, whether it is for yield or diversification. Short dated bond funds can play an especially valuable role, and are put to work in our lower risk Guardian Investment Solution portfolios.

The Short and Long of Bond Investing

First, some technical stuff. There is an inverse relationship between interest rates and bond prices, so when interest rates rise, bond prices fall. Why? A bond’s coupon payments and principal repayment date are fixed when it is issued. If these values are discounted to the present day at a higher rate of interest, their present value falls.

The duration of a bond is a measure of its price sensitivity to a change in interest rates. Broadly speaking, it tells you how much the bond price would fall if there were a 1% rise in interest rates. The principal factor in calculating duration is time to maturity, with coupon and payment frequency having a secondary impact.  Short dated bonds are less sensitive to changes in interest rates than long dated bonds because their principal is paid back sooner and could be reinvested at the prevailing rate, which at the moment is likely to be higher.

So what’s new?

Typically longer dated bonds yield more than shorter dated ones (the reasons are illustrated below). With interest rates at or near historic lows there has been a “hunt for yield”, which has pushed up demand for and therefore supply of longer maturity bonds. This has caused the maturity, and thus the duration, of bond indices to rise, a point for passive investors to ponder.

Time to cut duration?

With central banks tightening monetary policy, bond investors are worried about the impact of rising interest rates. Could switching to shorter dated bonds be a smart move? As we’ve seen, thanks to their lower duration or interest rate sensitivity, shorter dated bonds exhibit less price volatility than longer dated bonds. There are a number of other risks associated with bond investments (as the graphic shows), many of which also reduce with shorter maturities, due to greater certainty over shorter timeframes.  However, any extra risk allows the investor to demand additional reward. It is a question of balance, and critically, what does the portfolio need from its bond exposure?

When is shorter better?

Investment managers are using shorter dated bonds in their portfolios for two main purposes:

  1. An element in their fixed interest holdings
  2. An alternative to cash

Bonds are traditionally used as defensive assets within portfolios. Over the last 10 years equities* have exhibited more than double the volatility than gilts**.  We see this in our 20 year historic data, where bonds have acted as a good diversifier, with both gilts and corporate bonds*** less correlated to equities.

The main drawback to holding shorter dated bonds is that longer duration is a key contributor to risk control. Lowering duration, all else being equal, increases a portfolio’s riskiness and is likely to reduce its “efficiency” or return per unit of risk. However, as central banks start tightening monetary policy, commentators are wary that equity markets may come under pressure at the same time as interest rates rise.  In this scenario, being short duration may not be such a bad thing. Also, we are seeing a flattening of the yield curve which indicates that the premium for holding longer dated bonds is reducing, but without a corresponding reduction in risk.

Cash alternative?

Cash deposit rates have been very low since the financial crisis. After accounting for the effects of inflation, returns on cash have been negative.  Investing in short dated bonds offers a higher yield than deposit cash with greater price volatility. So, the investor will take some additional risk but be rewarded for it.

Guardian – theory put into practice…

We have followed our own logic by making a specific allocation to shorter dated bonds in our lower risk Guardian Investment Solution portfolios. As you would expect, these lower risk grades have lower equity allocations and therefore the diversification benefits of long duration bonds are not such an important factor. An improving yield outlook offers lower risk, giving retired investors some added confidence that they will achieve their income drawdown requirements.

*Equities, as measured by the FTSE World Index

** Gilts, as measured by FTSE Actuaries UK Conventional Gilts All Stocks Index

***Corporate Bonds, as measured by the iBoxx Sterling Corporates All Maturities Index

 



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