Duration is a word that is cropping up more often when talking about fixed income, especially in such volatile times, but in areas such as Europe are short-dated bonds actually worth the bother?
From a government bond standpoint the results are not encouraging. Statistics from the European Central Bank (ECB) on the spot rate or yield of AAA-rated euro area central government bonds show the spot rate for one-year bonds is just 0.22 per cent as of February 17.
The figure is not much better for other short-term bonds, with two and three-year spot rates of 0.47 per cent and 0.81 per cent, respectively. The further along the curve you go – in other words, the longer until a bond matures – the better the returns you get. Ten-year bonds yield approximately 2.68 per cent, for instance.
Richard Carter, fixed income specialist at Quilter, points out the ECB’s announcement of the long-term refinancing operation (LTRO) at the end of last year has driven many of the short-dated yields down aggressively in the past couple of months.
“You could actually probably argue that some of the value has gone out of them at the moment. The Italian and Spanish short-dated bond yields in particular have come down massively. Italian government bond yields have come down by approximately 4 per cent since early December, so they are not as cheap as they possibly were back then.”
Mr Carter suggests investors are looking to use them as a potential alternative to cash, as they do not want to take massive bets on buying more unpredictable long-term bonds.
“But if you’re looking at Europe, you’ve got so many different risks over there, with a central Greek default and everything that’s going on,” he says. “So while you might think a two-year bond is very low risk you never quite know, particularly in Europe.”
Jack Kelly, manager of the Standard Life Euro All-Government and Global Bond Sicav funds, says bond yields have fallen in core European markets to extremely low levels. Expectations for monetary policy moves are anticipated to be lower and even on hold for some time.
“The LTRO has given domestic banks access to three-year funding, which enables them to buy sovereign debt. What’s interesting now is that peripheral government yields, in the front end at least, are now very low relative to where they were. Spanish government two-year yields are roughly 2.5 per cent and Italian two-year yields are some 3 per cent.
“Short-dated bonds don’t particularly offer value for two main reasons. One is that if the global picture improves greatly – and we’ve started to see signs in the US of a sort of broad-based recovery – then it will challenge the expectation that monetary policy is going to be on hold long term. That would [in turn] put pressure on short-dated yields because they are at such extremes.
“On the flipside of that, if you get a continuation of synchronised austerity in Europe and lower growth, core markets yields would stay underpinned. Peripheral sovereign debt may come under pressure, given it has had such a good run, but also because the periphery needs growth in order to improve debt sustainability and improve debt-to-GDP ratios.”
Alternatives
An alternative could be short-dated investment-grade or high-yield bonds, which offer a higher income, albeit with more risk.
Tatjana Greil Castro, portfolio manager at Muzinich, points out the yield on these instruments in Europe is close to 4 per cent compared to approximately 0.3 per cent on a German government bond maturing in one to three years.
“If you look at what is perceived to be quality sovereign, you get a big pick-up, and that is really where the value lies. Sovereigns are heavily indebted, they are very non-transparent in terms of what information they are publishing on GDP and on their liabilities, and they have been increasing their indebtedness in response to the recession in 2008-09 in order to bail out the banks.
“All these things have made governments less creditworthy, whereas corporates have been cutting costs and improving their balance sheets. They’ve actually reduced leverage and increased their liquidity, and generally you know about future liabilities that the companies have. So there is far more transparency in companies and fundamentally they are very, very sound.”
In terms of choosing short-dated bonds, Ms Greil Castro points out that volatility is more limited and capital appreciation becomes a larger part of the return.
“In times of heightened uncertainty there are significant sell-offs, even for fundamentally strong companies, just because investor sentiments are poor. [However,] these will be limited in the short end [of the bond curve], and this reduces volatility.”
Picking the right short-dated bonds depends on the individual merit of the company, but even some peripheral names such as Portugal Telecom can provide good returns as they have enough liquidity in the short term to overcome a lack of market confidence in the country itself.
“Portugal Telecom has bonds outstanding that are coming due at the end of March and the company already has the cash on balance sheet to repay that bond, for instance, so we don’t have to worry about markets being opened or closed because the company already has the funds there to repay the debt.”
Refinancing
That’s not to say corporate bonds will not be affected by a further escalation of the eurozone crisis, but according to Ms Greil Castro the key thing to be aware of is risks involved in companies refinancing their debt, particularly high-yield bonds.
“High-yield companies generally do not have the liquidity to repay a bond when it comes due, so most of the time they would have to come to market to refinance. We have to pay particular attention to whether the company is in good enough shape that the market will refinance the debt and extend the maturities.
“But corporates have strong fundamentals and transparency and it’s still a fixed income instrument. The short end, in particular, still offers very good value of 4-5 per cent, so you don’t give up much going shorter but the volatility is significantly reduced.”
However, Mr Carter notes that while government bonds are providing little more than the return on cash, people like them because they are virtually ‘risk free’.
“If people are looking for something with a bit more yield or return they’ve got to take the risk of buying high-risk corporate bonds or Spanish or Italian bonds, which might not be right for everyone because they don’t make great cash substitutes.
“They’ve got to be very careful. These bonds can move a lot, and if Greece defaults then you could see worries about the whole banking sector and everything coming back with a vengeance. People have to be cautious about what they want.”
Nyree Stewart is deputy features editor at Investment Adviser
