Short-Maturity Strategies to Close Out the Year
For fixed income investors, the current environment warrants an approach that limits exposure to rising rates and high levels of volatility. We believe short-maturity strategies offer a way to manage these risks, as they can be used to reduce volatility, which could help as liquidity starts to dry up toward year-end. In addition, while reducing duration risk often implies forfeiting yield, the current flatness of yield curves means that short-duration strategies compare favourably against their all-maturity counterparts.
The great credit re-pricing
Bond markets remain volatile, with the start to Q4 seeing the US 10-year yield rise to a new cycle high of close to 4.25% before falling back to 4%. While the market now appears better supported, the path for rates will be determined by inflation. If inflation refuses to fall, optimism that the market has priced peak rates may give way to renewed selling of bonds – similar to what happened over the summer. For this reason, in the Q4 Bond Compass we suggested short-duration positions, limiting exposure to rising rates and high levels of volatility.
Reducing duration risk often implies forfeiting yield. However, this year’s aggressive re-pricing of the profile for central bank rate rises means this trade-off is less of a concern now that yield curves are quite flat. Indeed, the money markets imply Fed rates rising to May 2023 before easing back, while for the ECB and the BoE they are seen topping out over the summer of 2023.
For those investors looking to benefit from the higher yields on offer, post the summer correction in bond prices, yield can also be enhanced by focusing on investment grade (IG) credit strategies rather than straight government bonds. The flatness of the curve means that the yield to worst on the Bloomberg 0-5 Year Sterling Corporate Bond Index is 5.85%, just 3bp below that for the all-maturity Bloomberg Sterling Corporate bond Index1.
In other words, the trade-off between duration risk and yield looks far more favourable at the front end of the curve than for longer maturities. Figure 1 provides an illustration, where the horizontal axis shows the amount of yield per year of duration2 for various IG credit strategies. The four highest yielding ones relative to their duration risk are all short-maturity indices. Note also that the Bloomberg SASB Euro Corporate 0-3 year ESG Ex-Controversies Select Index offers a slightly better trade-off than the market-weighted Bloomberg Euro Corporate 0-3 Year Index.
Figure 1: Investment Grade Credit Has Undergone a Significant Re-Pricing
Are credit spreads wide enough?
The risk with opting for credit rather than government exposure is that a growth slowdown is in motion. The composite PMIs for the US, euro area and UK were all below 50 for October, signalling contraction. With limited visibility on how extreme the slowdown may become, investors should exercise caution around lower-rated exposures. However, it is also clear from Figure 1 that some IG exposures have already priced a considerable risk of an economic slowdown. The vertical axis shows the extent to which the option-adjusted spreads (the credit risk premium) have widened since the end of 2021. Euro and sterling bonds have widened by over 100bp, taking them to levels close to the extremes seen during the peak of the COVID crisis in early 2020. This is a considerably larger re-pricing than their USD-denominated counterparts.
High energy costs in Europe and their impact on growth and inflation have forced the credit premium materially wider in Europe than in the US. However, there are some signs of relief, with natural gas now having largely reversed the rise in prices seen since June3. This should reduce the tail risk scenario of a deep and prolonged slowdown in Europe but is not yet reflected in credit spreads, which remain close to their wides.
In summary, short-maturity strategies have several appealing features.
- They can be used to reduce price volatility during what has been a historically volatile period. This may be desirable into year-end as liquidity starts to dry up.
- The flatness of curves means that there is little ‘give-up’ of yield by sticking to the short end. Indeed, short-maturity strategies show a far higher yield per year of duration than their all maturity counterparts.
- Credit spreads in Europe price a meaningful slowdown. They have yet to respond to the easing of energy prices, which should reduce risks of a deep recession, or to the slightly more dovish tone to the ECB at last Thursday’s meeting.