Fixed IncomeNov 16 2022

Short-dated bond market offering best opportunity in a decade

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Short-dated bond market offering best opportunity in a decade
AP Photo/Ahn Young-joon

Recent turmoil in fixed income markets has thrown up opportunities for investors after years of ultra-low interest rates, experts have said.

Since the start of the year, the price of government and corporate bonds has crashed, as rising interest rates have meant investors are able to gain similar returns from less risky assets.

This led to huge outflows from fixed income strategies, with more than £5.7bn withdrawn from UK bond funds in February and March this year, according to the Investment Association.

The UK government bond market in particular suffered in September as the tax cuts offered by the "mini" Budget spooked market participants, driving gilt yields up to record levels.

The large repricing experienced since the beginning of the year has created the best buying opportunity in UK short-dated bonds since 2008Nicolas Trindade, AXA Investment Managers

For new investors, these high yields and correspondingly low prices are making the market more attractive than it has been in decades, experts have said.

Investors can now get a similar yield in short dated UK gilts than they would have got in high yield bonds a few months ago, said Nicolas Trindade, a senior portfolio manager at AXA Investment Managers.

“The large repricing experienced since the beginning of the year - and particularly since the 'mini' Budget - has created the best buying opportunity in UK short-dated bonds since 2008,” he said.

Trindade manages the AXA Sterling Credit Short Duration Bond Fund, which is currently yielding 6.1 per cent for an average credit rating of A- and duration of 2.1 years.

"This yield is higher than the one of the all-maturity Sterling Corporate universe, for only a third of its interest rate risk," he explained.

The repricing has also left the cash prices of bonds significantly below par, which gives investors an easy win as short-duration bonds reach maturity.

Active management, including the use of cash, will continue to be key to driving returnsDuncan MacInnes, Ruffer Investment Company

“As bonds mature at par, this ‘pull-to-par’ effect should be a tremendous contributor to performance, particularly since around 40 per cent of our portfolio will mature over the next two years,” Trindade said.

Copia Capital has launched a short-duration bond portfolio to take advantage of this opportunity.

Managing director of Copia Capital, Robert Vaudry, said the company had already been introducing a short-duration bond fund into several of its multi-asset portfolios, and advisers were keen on the low risk and attractive yields.

“The feedback to us was that, if we could launch a pure mandate possessing the same low risk characteristics and attractive yields, their clients would find this appealing,” he added.

The fund is aimed at advisers with clients who want returns that are higher than cash, but who are cautious about investing in equities.

Opportunities amid volatility

Meanwhile, there are other potential opportunities in the fixed income market.

The managers of the Ruffer Investment Company have moved into long-dated US inflation-linked and conventional bonds, as well as some long-dated UK index-linked bonds.

The combination of higher yields and growing recession risk now makes these bonds more attractive than for many years.

The trust has a 19.5 per cent exposure to short-dated bonds, with its biggest holding (8.9 per cent) in UK treasury index-linked bonds maturing in 2024. 

Duncan MacInnes, investment director at the Ruffer Investment Company, explained that the world has moved into a new regime characterised by higher and more volatile inflation.

He expects this structurally higher inflation to maintain the bear market in equities and bonds. 

“Inflation will also be more volatile and there will be periods when it might decline meaningfully,” he said. 

“During these phases of falling inflation, we will need to participate in potentially powerful bond rallies…active management, including the use of cash, will continue to be key to driving returns.”

Steve Ellis, global chief investment officer at Fidelity International, agreed, saying the turmoil in fixed income markets now means investors can buy government bonds yielding more than that offered by big multinationals.

We are watching global liquidity carefullySteve Ellis, Fidelity

These are much less risky, he said, provided countries and companies do not default.

However, he said big risks remain, despite these attractive valuations.

“The affair around the 'mini'-budget, culminating in the resignation of Liz Truss as prime minister [in the UK], may just be the first sign of the cracks appearing in the global system. 

“We are watching global liquidity carefully…it is still unclear whether the far wider spreads on some pieces of the bond market account for the scale of the recession - and defaults - in front of us.”

Ellis is not alone in flagging the importance of liquidity in bond markets as a sign of underlying health, as concerns rise over the implications of the fragility of bond markets, which could result in higher odds of a "financial accident".

Markets overpricing recession risk

Richard Woolnough, a fund manager at M&G, has a different rationale for why fixed income markets are currently attractive.

Far less damage is done when the slowdown hits a strong economyRichard Woolnough, M&G

He is encouraged by the discounts in the corporate bond market, which is currently pricing a severe recession.

“[This] would take a heavy toll on company profits…this is a scenario we do not adhere to,” he said.

Most observers in the US and Europe tend to ignore the good news, he explained, and he sees employment as an “excellent barometer” of the state of the economy.

“We believe it is in better shape than is generally thought.”

Woolnough manages the M&G Optimal Income Fund, which is currently overweight investment grade corporate bonds, as well as high-yield bonds.

Companies have relatively little debt and will be able to weather further interest rate hikes, and although there will be defaults, Woolnough expects there to be fewer than the market expects.

“When an already sluggish economy continues to contract, the defaults pile up,” he said.

“But far less damage is done when the slowdown hits a strong economy.”

sally.hickey@ft.com