A short duration investment approach may prove beneficial in the current environment.
By Tatjana Greil-Castro, Portfolio Manager & Co-Head of Public Markets at Muzinich & Co.
With moves in rates impacting fixed income across the board, and growing concerns of a recession on the horizon, we believe a short-duration investment approach may prove beneficial in the current environment.
Short-dated bonds tend to offer several benefits that can insulate investors from extended periods of volatility/rising interest rates.
Less Sensitivity to Interest Rate and Spread Duration Risk
The shift to higher interest rates has begun. While interest rate rises from the U.S. Federal Reserve and European Central Bank have largely been priced in by markets, there is a risk of a further rise in yield that may be less associated with higher interest rates and more with wider credit spreads.
In this context, short-dated bonds can potentially provide better protection against rising interest rates as they are less sensitive to rate rises than their longer-duration peers.
Potential for Lower Volatility: «Pull-to-Par» Effect
Short-dated bonds of creditworthy companies tend to display less price volatility than their longer-dated counterparts. Short-dated bonds don’t often trade below par. When they do, they tend to reverse quickly.
They also tend to converge back to par as the bond approaches maturity. This is known as the «pull-to-par» effect. This also helps short-dated bonds recover from drawdowns.
«Roll Down» the Yield Curve Benefit
The «roll down» effect maximizes the bond’s yield by taking advantage of the yield curve shape. This means that when the interest rate curve is positive, as the bond matures and «rolls down» the curve, all things being equal, the yield will decrease but the price will go up (yield and price move inversely to each other).
This characteristic is particularly acute for short-dated bonds as the yield curve is usually steeper at the short end of the curve. Therefore, the positive ‘roll down’ effect can be more significant than it is for longer-dated bonds.
Source of Carry
For short-dated bonds, carry is a source of return. Carry helps offset a fall in the price of a bond. As prices drop, the carry rises.
The higher the carry, the quicker a negative price move can be offset by the consistent carry.
Is the worst behind us? It seems so
What does this mean for investors? Looking exclusively at the carry element, if we were to see a similar rise in interest rates and widening of spread as we have over the past 6 months, it will not result in the bonds incurring the same sort of losses. In our view, the worst is now behind us.
The first half of this year has been particularly painful because we started with low carry, a negative-yielding market and no protection, followed by a sharp price decline. Now, the carry is steadily offsetting the experienced price decline. If we see future price declines, the carry will go higher and help offset the move in price.
Short duration strategies may support better returns
In our view, we are now in a different situation when compared to the start of the year. For short-duration strategies, carry, «pull-to-par», «roll down» and active management can all provide a backstop to dampen volatility, and is likely to support better returns for the second half of 2022, even in a complicated macroeconomic environment.
Tatjana Greil-Castro is Co-Head Public Markets at Muzinich & Co. and manages the Muzinich Enhancedyield Short-Term strategy and the Muzinich Sustainable Credit strategy. She has a Ph.D. from the London School of Economics, a Master's from the Kiel Institute of World Economics in Germany and an M.Sc/B.S. in Economics from the University of Vienna.
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Muzinich & Co. referenced herein is defined as Muzinich & Co., Inc. and its affiliates. This material has been produced for information purposes only and as such the views contained herein are not to be taken as investment advice. Opinions are as of date of publication and are subject to change without reference or notification to you. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments and the income from them may fall as well as rise and is not guaranteed and investors may not get back the full amount invested. Rates of exchange may cause the value of investments to rise or fall. Emerging Markets may be more risky than more developed markets for a variety of reasons, including but not limited to, increased political, social and economic instability; heightened pricing volatility and reduced market liquidity. Any research in this document has been obtained and may have been acted on by Muzinich for its own purpose. The results of such research are being made available for information purposes and no assurances are made as to their accuracy. Opinions and statements of financial market trends that are based on market conditions constitute our judgment and this judgment may prove to be wrong. The views and opinions expressed should not be construed as an offer to buy or sell or invitation to engage in any investment activity, they are for information purposes only. Any forward-looking information or statements expressed in the above may prove to be incorrect. Muzinich gives no undertaking that it shall update any of the information, data and opinions contained in the above. Issued in the European Union by Muzinich & Co. (Ireland) Limited, which is authorized and regulated by the Central Bank of Ireland. Registered in Ireland, Company Registration No. 307511. Registered address: 32 Molesworth Street, Dublin 2, D02 Y512, Ireland. Issued in Switzerland by Muzinich & Co. (Switzerland) AG. Registered in Switzerland No. CHE-389.422.108. Registered address: Tödistrasse 5, 8002 Zurich, Switzerland. 2022-07-15-9033
