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Diversified Alternatives – introducing short-dated bonds

For financial professionals only

This is the third in a series of 5 articles exploring our new Diversified Alternatives asset class. Here, Colin Morris discusses the merits of short-dated bonds.

We’ve previously described diversified portfolio assets such as equities, bonds or property as cogs in a machine. Each cog has its own purpose and contributes to the overall outcome.  Our short-dated bonds ‘cog’ brings a number of unique characteristics to our Diversified Alternatives asset class.

What are short-dated bonds and why are they important?

Short-dated bonds are bonds close to maturity (final payment) and are considered less risky, as the likelihood of default is less than longer dated bonds. However, there are other risks to investing in bonds beyond maturity, including creditworthiness (the reliability of the issuer to make payment) and duration (the sensitivity to interest rate changes).  As time passes and the maturity date approaches, the bond duration decreases.

Bonds are less volatile than equities and can offer some protection against falling equity prices, whilst retaining a degree of growth when markets are rising.

In certain environments, as we’ve seen in recent months, bonds can struggle. When interest rates are rising, bond yields generally increase while their prices fall. With interest rate expectations continuing to grow as central banks try to tackle inflation bonds are under pressure, particularly the longer dated bonds more susceptible to rising interest rates.  For fixed interest bonds, especially those with a longer maturity, inflation is a heightened concern as it erodes the real value of payments – another adverse impact.

Cash may offer nominal protection, but its real value is eroded in periods of high inflation. This is where we feel short-dated bonds (albeit different to cash) can offer additional value, with less sensitivity to changes in interest rates than longer dated bonds.

What are the portfolio benefits?

We hold short-dated bonds within our Diversified Alternatives asset class, alongside other non-traditional assets such as Property, Absolute Return and Infrastructure.  Compared to these, short-dated bonds are highly liquid and less volatile. The high frequency of bonds reaching maturity generates a steady cash stream for the underlying fund manager and the lower duration dampens volatility. The Diversified Alternatives asset class benefits from the diversification brought by short-dated bonds, providing a helpful offset against the equity component of Infrastructure.

Bringing these characteristics into the portfolio is key to achieving our target for Diversified Alternatives – low volatility, positive real returns and low correlation to fixed interest and equities.

What are the risks?

Short-dated bonds typically reduce the duration risk, but aren’t completely immune to an interest rate change.  And while they do provide uncorrelated benefits, in times of extreme stress they would likely suffer alongside longer dated bonds and equities – but to a far lesser extent.

In exchange for the greater protection provided against duration, short-dated bonds offer a lower yield profile, so may not be suitable where a high income level or greater level of return is needed. The chart below illustrates the lower yield profile for shorter dated bonds (highlighted in green) compared to wider bond markets (in grey and the source of the arrows). In this example, the vertical axis represents the yield while the horizontal axis represents the modified duration in years, measuring the price change in a bond for a 1% interest rate change. It shows a clear reduction in modified duration for the shorter dated bond markets.

Source: https://www.am.pictet/en/us/global-articles/2021/monthly-market-views/fixed-income/short-term-bonds

The power of diversification

Short-dated bonds have a distinct risk and return profile, attractive to investors seeking liquidity and low volatility alongside some return. They are not expected to shoot the lights out, but when combined with other assets, the benefits of diversification are clear in our long-term modelling. Diversified portfolios across a number of assets can achieve better consistency of risk adjusted returns over the longer-term.