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Weekly ETF Brief

Navigating Uncertain Bond Markets with Short-duration Credit

It has been a challenging start to the year for bond investors. The types of strategies that have performed strongly have been shorter duration, risk-on assets such as high yield, whereas faith in the duration trade has not yet been rewarded. 

4 min read
Senior Fixed Income ETF Strategist

The strength of the US economic activity data and stickiness of inflation have been a genuine surprise and have pushed central bank easing expectations further out into the year. Even in Europe, where soft growth and CPI data that continue to converge on the European Central Bank’s (ECB) target creates a strong case for rate cuts, the first cut has been pushed back from March to June. 

The compression of credit spreads has provided some protection for investors in investment-grade credit, but any assets with a meaningful amount of duration have struggled. Volatility in returns at the turn in the cycle is not unusual, as the market tries to second guess central banks which, in turn, are trying to estimate how growth and inflation are likely to evolve. 

Given this uncertain backdrop, a more defensive approach is to focus on shorter maturity investment-grade strategies. There are several benefits:

  • Higher yields on offer. Investment grade offers a pick-up to government yields, even at the front end of the curve. For instance, the Bloomberg Euro Corporate 0-3 Year Total Return Index has an option-adjusted spread to governments of over 75 basis points (bps)1. This may not be generous by historical standards, but with outright yields currently high and the curve inverted, there is little additional yield to be harvested by extending out along the curve. This yield is the key driver of total returns in an environment where rates are relatively stable.
  • Shorter maturity generally equates to a lower duration risk. This means the fund may have a lower sensitivity to any rises in rates. The Bloomberg Euro Corporate 0-3 Year Index has just a third of the duration of the all-maturity index. This enables it to better survive swings in sentiment over the precise timing of an ECB easing. 

The yield and duration can be combined to create a ‘breakeven’ rate. This is the yield-to-worst divided by the duration and is an approximation of how far yields can rise before the price loss from the index wipes out the annual yield. The breakevens for the Bloomberg 0-3 Year Euro Corporate Bond Index and the Bloomberg Euro-Aggregate: Corporates Index are shown in Figure 1 below. This should make clear how much more defensive the short-end exposures are: yields have to rise by over 270 bps on the 0-3 year index before the index yield is neutralised, against just over 85 bps for the all-maturity index2

Turn of the Cycle

There are two arguments against opting for short-duration credit strategies. The first is that credit spreads are already historically tight. This is certainly the case relative to where spreads have been during the low/zero rate regime. However, stretching further back to the 2006-2007 period, option-adjusted spreads on the Bloomberg Euro-Aggregate: Corporates Index traded consistently at around 50 bps when ECB rates were around current levels. The higher all-in yield of the strategy and therefore higher breakeven rates may encourage bond investors to accept tighter spreads.

Nonetheless, tight spreads do raise the risks that a sharp slowing in growth would cause spreads to blow out. There are few signs that data is weakening from current levels. It is also worth noting that spread widening would not result in negative returns if the decline in underlying government bond yields is a main driver of the spread widening. 

The second argument is that with central banks on the cusp of cutting rates, it is time to be taking on duration risk. However, history suggests that sticking with the front end of the curve can produce better returns at the start of the cycle. Figure 2 shows the rolling 13 week/13 week (effectively quarter-on-quarter) returns from the Bloomberg 0-3 Year Euro Corporate Bond Index and the Bloomberg Euro-Aggregate: Corporates Index. Returns were higher for the 0-3 year index in the early stages of both the 2008-2009 cycle and the more curtailed 2011 cut cycle. This may be a reflection of the curve steepening move that occurs as cuts get underway, or general uncertainty over the extent of cuts that a central bank will deliver at the start of the cycle. 

Non-euro based investors can still participate through a hedged share class ETF. With EUR rates lower than those in the US or the UK, the currency hedging process is additive to yield. So the 1-month forward EUR/USD rate increases yield by just over 13.5 bps and for EUR/GBP close to 9.5 bps3

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