Advantages of short duration in a period of rising rates

A short-term investment approach may prove useful in the current environment.

Tatyana Greil-Castro, portfolio manager

MUZ - Tatyana Greil-Castro
Tatyana Greil-Castro

Given the widespread impact of changes in bond rates and growing fears of a recession, we believe that a short-term approach to investing may prove beneficial in the current environment. Short-term bonds typically offer benefits that can protect investors during extended periods of volatility and rising interest rates.

Less sensitivity to rates and duration of spreads

The transition to higher interest rates has begun. Although markets have largely factored in interest rate hikes from the US Federal Reserve and the European Central Bank, the risk to further rising yields may be more related to widening credit spreads. In this environment, short-dated bonds can offer better protection against rising rates because they are less sensitive than their longer-dated counterparts.

Lower volatility potential: the pull-up effect

Short-term corporate bonds tend to exhibit lower volatility than their longer-term counterparts. Short-term bonds rarely trade below par, and when they do, their value rises quickly. They also tend to approach par as they approach maturity. This is known as the “draw-to-par” effect, which allows short-term bonds to offset losses.

The advantage of “rolling” on the yield curve

The roll-in effect aims to maximize a bond’s yield by taking advantage of the shape of its curve. Thus, when the yield curve is positive, as the bond matures and therefore “falls” down the curve, its yield decreases but its price increases (yield moves inversely to price). This characteristic is especially true for short-term bonds because the yield curve tends to be steeper at its short end. Thus, the positive effect of reduction may be greater than for long-term bonds.

Transfer source

For short-term bonds, carry is also a source of income. Carry allows to compensate for the fall in the price of the bond. When prices fall, carry increases. The higher the carry, the more negative price movement can be offset by a large carry.

Is the worst over? It seems so

What does this mean for investors? Taking the carryover element alone, if we were to see interest rates rise and spreads widen similar to those seen over the past 6 months, bonds would not have suffered the same level of losses. In our opinion, the worst is behind us. The first half of this year was particularly painful as we started with low carry, negative market returns and lack of protection, followed by a sharp drop in price. Today, carry is gradually compensating for the observed price decline. If prices continue to fall, carryovers will increase and offset this development.

Short duration for better performance

In our opinion, today’s situation is different from the one at the beginning of the year. For short-term strategies, carry, pull-to-par, roll-down, and active management can act as a buffer against volatility and should support outperformance in the second half of 2022, even in a challenging macroeconomic environment.

Muzinich & Co. referred to herein is defined as Muzinich & Co., Inc. and its branches. This material is for informational purposes only and any opinions contained herein should not be construed as investment advice. Opinions are current as of the date of publication and are subject to change without warning or notice. Past performance is not a reliable indicator of current or future performance and should not be the only factor to be considered when selecting a product or strategy. The value of investments and the income from them may both decrease and increase and are not guaranteed. Currency exchange rates can cause the value of investments to rise or fall. Emerging markets may be riskier than more developed markets for a variety of reasons, including, but not limited to, increased political, social and economic instability, increased price volatility and reduced market liquidity.

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