Over the past three years, we have seen the launch of 16 funds using short-dated bond strategies.
This approach has become widely available to retail investors and the Investment Association registers close to 50 funds.
How could we explain the development of this strategy? What are the risks and benefits of accessing the funds?
2016 was a pivotal year for global bond markets. On December 17 2015, the then-US Federal Reserve chairwoman Janet Yellen decided to begin raising rates, as global growth stabilised.
This episode marks the end of the monetary experiment of quantitative easing launched by central banks across the world.
Following the global financial crisis in 2008, major central banks decided to launch QE and other bond purchasing programmes to restore faith in the financial system and deal with inflation, which was below target levels.
To many bond investors and veteran bond portfolio managers, the move by Ms Yellen meant the end of the bond bull market.
It was the end of a good time – a decade-long rally driven by decreasing bond yields across the globe.
But the message to investors was clear: do not count on duration for your future returns.
The normalisation of yields on global bond markets had repercussions on return expectations, but also on risk. The sensitivity to interest rates, or duration, is the primary risk factor for most bond investors.
The duration ratio expresses the change in price for a 1 per cent change in interest rates. It is the only driver of risk for conventional government bonds.
Unsurprisingly, investors asked asset managers (or asset managers foresaw the demand) for solutions to isolate them from this risk: here lies the reason for the explosion of short-dated bond fund launches.
Fund managers can effectively hedge the risk of interest rates going up by building portfolios of short-dated bonds.
As the primary risk is hedged out by investing in bonds with low duration, the volatility is suppressed to low levels – between 1 per cent to 3 per cent.
Despite this, there are extra risks to consider before investing in those strategies.
For a start, short-dated bond managers typically invest in corporate bonds, which carry credit risk, ie the risk of a company defaulting and not meeting its repayment obligations to the bond holder.
On top of this, like other managers, short-dated bond managers could get their bond picking incorrect. For example, investors could be overexposed to company-specific risk.
The performance of those strategies in the fourth quarter of 2018 highlighted the extra risk taken by investors.
Credit spreads (the difference between corporate and government bond yields) widened as fears of recession increased.
Unsurprisingly, these strategies failed to protect investors from the downside, as they all carried some credit risk.
The chart highlights the maximum drawdown for a few short-dated bond funds.
