'Funny' isn’t usually a word I’d use in an article about fixed income, but I did hear a humorous quote recently: “The bond bull party isn’t over until the Fed lady sings.”
It made me smile anyway. As we all wait with bated breath to see if Janet Yellen raises interest rates again next month, a number of other factors are also lining up to create problems in the bond world.
Firstly, inflation is nudging up. The rise in the oil price since its lows at the start of the year, combined with the post-EU referendum currency shock, has lifted inflation to a two-year high and it’s likely – in the short term at least – to rise further.
Inflation is the enemy of bonds. Because the income paid is usually fixed at the time they are issued, high or rising inflation can be a big problem, as it erodes the real return.
Liquidity is another, well-publicised, concern. And, given some property investors have already had a sharp reminder of liquidity issues, wariness has increased. Another side to this coin is that less liquidity has led to higher transaction costs.
Volatility has also been an issue for some time. Starting in earnest back in April 2015, the past 18 months have continued in the same vein and I see no reason for this to stop any time soon. We still have a potentially ‘EU threatening’ Italian referendum in December, followed by elections in France and Germany in 2017. We also have heightening tensions with Russia over Syria and an economic slowdown in China.
And of course, if and when the Fed does raise rates, the big risk is the capital-eroding effect of rising yields.
We know that many investors need bonds for diversification or to stay in line with benchmarks. For those investors, short duration bonds could be the answer. Due to regular cashflows from maturing bonds and coupon income, turnover is low, avoiding performance leakage from additional costs.
Investing in short duration bonds not only reduces sensitivity to rising government bond yields but also sensitivity to credit spreads. On top of this, a higher level of reinvestment from maturing bonds allows for a closer alignment with rising yields. In other words, the cashflows from the maturing bonds can be reinvested into the higher yields becoming available on the market. These factors also help to dampen volatility and drawdown, when compared to the wider market.
A fund that does all of this and more is Axa Sterling Credit Short Duration Bond. It invests only in high-quality corporate bonds with less than five years to maturity.
The manager, Nicolas Trindade, looks for short duration bonds issued by companies unlikely to default during the period and he typically holds them right up to maturity to reduce the trading costs. The portfolio is well diversified and structured so that approximately 20 per cent of the holdings mature each year. That is a nice buffer and a good pot of money to put to use as and when yields start to rise again.
The fund benefits from a strong team, a simple strategy and great resources. By targeting an often overlooked part of the bond market, Mr Trindade is able to exploit a persistent valuation anomaly to generate low-risk income for investors. Historically this fund has performed better than peers in down markets.
Darius McDermott is managing director at FundCalibre
