Fixed IncomeDec 8 2015

Are short duration funds most at risk from US hike?

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Are short duration funds most at risk from US hike?

The US Federal Reserve’s tightening of monetary policy may hit short-duration bond funds more than longer maturity peers, according to Schroders US fixed income head Wes Sparks.

With the central bank widely expected to raise its interest rate following its December 16 meeting, attention has turned to investors’ reaction.

Although the move has been telegraphed by policymakers, Mr Sparks hinted that some investors were misguided in their assumptions over the potential impact.

Short-duration bond funds have grown in popularity since 2010, given short-dated debt is less sensitive to interest rate rises than medium- or long-dated bonds. This dynamic would typically produce a steeper yield curve in times of higher rates, as yields rise more significantly at the back end of the curve than at the front end on a relative basis.

However, the US yield curve has been flattening in recent months in spite of the prospect of higher rates. Mr Sparks backed this dynamic and said he was “concerned” for short-duration products.

“Contrary to what you might think, we are more constructive on the back end than the front end... we have a high conviction that a modest increase in US Treasury yields [and corporate bond spreads] would see institutional investors step in and buy,” he said, speaking at Schroders’ New York media conference.

“The front end is [still] not priced properly for a rate hike campaign.”

The manager said he feared an “exodus” from the front end of the curve at the start of 2016, when investors read their fourth-quarter statements and saw that even short-dated debt was not entirely immune from the impact of an increase.

Meanwhile, a lack of inflationary pressure is adding to the relative calm at the long end of the curve.

But Mr Sparks’s view is not shared by all managers. Jim Caron, a senior member of Morgan Stanley Investment Management’s global fixed income team, thought the longer end of the curve was most at risk.

Mr Caron said that while the yield curve might eventually flatten, he expected a rise to produce a steepening in the first instance. “It is the back end that is most vulnerable,” he said.

“The initial move will be a steeper curve...I think most hikes [this year and next] are priced in at the front end.”

Mr Caron expects a further three increases in 2016 in line with market expectations, whereas Mr Sparks predicts four.

This relatively subdued pace of hiking could mean the return of inflationary pressures, the former suggested, a factor which has not yet been priced into the likes of 30-year US Treasuries.

Mr Caron predicted that 30-year Treasury yields could rise from the current level of 3 per cent to as high as 3.7 per cent by the end of 2016 as a result.

Turning his attention to the state of the fixed income market in general, he said that a greater need for diversification made it more difficult for larger funds to operate effectively.

A potential end to the bull market in bonds would hinder larger managers, who were unable to invest in some parts of the market, he suggested.

Any unconstrained funds larger than $8-10bn (£5.3-6.6bn) in size would be unable to meaningfully invest in diversifying areas such as New Zealand government debt, for example, Mr Caron said.

Similarly, bigger funds were “stuck buying BB [rated debt]” in the corporate credit markets, because most supply was concentrated on this area. “For the past 30 years size did not really hurt performance; suddenly, size does matter,” he added.