Tuesday, August 21, 2018

Not all short-duration strategies are created equal

By David Nagle, guest columnist

Today’s fixed income investors face a number of formidable challenges. Interest rates remain low by historical standards but appear poised to rise (or continue rising) amid a favorable economic backdrop and shifting global monetary policy. At the same time, credit spreads remain fairly tight across many fixed-income sectors, meaning investors are often not being adequately rewarded for taking on credit risk. 

This environment has left many investors strapped for yield and return, potentially forcing them to step outside their normal risk tolerance to pursue their investment objectives. For example, some investors may have either gone down in credit quality or reached for yield at the longer end of the yield curve, which is more sensitive to interest rate movements. In so doing, investors may be exposed to significantly more credit or duration risk than they realize (in other words, more vulnerable to market volatility and possible capital depreciation going forward). 

An appropriate strategic allocation to a high-quality, actively managed short-duration bond strategy may allow these investors to reenter their comfort zone—not only today but for the long term as well. This type of strategy can potentially play three distinct roles in investor portfolios. 

  1. SUBSTITUTE FOR LONG/INTERMEDIATE ALLOCATION: Faced with today’s fixed income headwinds, many investors have been rethinking their allocation to the long end of the yield curve. For core bond investors seeking an attractive balance of risk and reward, the solution may be an actively managed intermediate- or short-duration strategy that is designed to mitigate market volatility without meaningfully sacrificing return.
  2. AN ALTERNATIVE TO MONEY MARKET FUNDS: For investors with short-term cash needs, capital preservation is paramount, often making low-yielding (albeit ultralow-risk) money market funds the vehicle of choice. Investors seeking a better risk-adjusted return, while still retaining a high degree of liquidity and principal stability, may find a high-quality short-duration bond strategy to be a viable alternative.
  3. SHORT-DURATION BOND ALLOCATION: In general, short-term fixed income instruments are acknowledged as being less sensitive to interest rate movements than their longer-term counterparts. Thus, a short-duration bond strategy may provide fixed-income investors with enhanced diversification across the bond maturity spectrum, along with a natural hedge against the potentially negative impact of rising rates. 

A Vast Universe of Short-Duration Strategies 

Many investors mistakenly think of the short-duration bond universe as a monolithic group of strategies that all share one key characteristic—the ability to help protect against rising rates or, more generally, to help reduce portfolio volatility.

In reality, the universe is large and quite diverse, with notable differences among individual strategies. For example, passive duration strategies, in particular, may not supply much of a rate hedge because many do not attempt to actively manage interest rate risk, while some higher-risk active duration strategies may have oversized allocations to lower-quality credits. And of course, yield and performance can vary widely from one strategy to another.

As with any portfolio allocation, it’s important to consider your options carefully before choosing a short-duration bond strategy.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Barings or TEXPERS. 

About the Author
David Nagle is the Head of Barings Multi-Strategy Fixed Income Group. He is responsible for the portfolio management of the firm’s investment grade strategies. Nagle has worked in the industry since 1986 and his experience has encompassed multi-sector portfolio and risk management, and asset allocation. Dave holds a bachelor's degree in Economics and Finance from Lafayette College and is a member of the CFA Institute.

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