Increasing volatility and rising interest rates – not really the cocktail of choice for the risk-averse credit investor. But how can investors maintain their market exposure while enjoying an acceptable risk-reward profile without too much volatility? Short-maturity strategies offer a compelling solution as they deliver attractive risk-adjusted returns and are less volatile, as well as offering perhaps less obvious diversification and liquidity benefits.
In our recently published Credit Quarterly Outlook, we take a cautious stance. Market fundamentals remain positive and the global economy looks strong, but risky assets are expensive across the board – from investment grade to high yield, and from US Treasuries to emerging market debt. But it’s not all doom and gloom. This scenario will cause higher dispersion in our universe and this offers opportunities. Short maturity bonds, for example, are a smart way to outperform from both a strategic and tactical standpoint in this kind of market environment. US 5-year bond yields have moved up by 100 bps in the last six months and the broader global investment grade credit market (Bloomberg Barclays Global Aggregate Corporate Index) has fallen 2.0%, while the total return for short-dated global investment grade credits (Bloomberg Barclays Global Aggregate Corporate 1-5 years Index) has only declined by 0.90%.
Short maturity – a smart approach in the current market environment
One strategic argument for short maturity bonds is that they enable investors to capitalize on the low-risk anomaly. This phenomenon is well known in equities, but there is convincing evidence that it also applies to credits, where low-risk bonds produce higher risk-adjusted returns. The chart below shows that short-dated credits have a higher Sharpe ratio than longer-dated ones across the various rating categories.
Investors have a tendency to prefer and thus overpay for high-risk bonds. This causes a low-risk anomaly where low-risk securities empirically have a superior risk-return profile to high-risk ones. Benchmarked investing means portfolio managers are often incentivized to outperform a specified benchmark index and longer-maturity bonds often have risk profiles that are more closely aligned with market benchmarks than bonds that are nearing maturity. This is further amplified by a ‘hot money’ effect: money flows into asset classes that perform well. This acts as a further incentive for portfolio managers to buy high-risk credits; for example, because they tend to outperform in bull markets. Investors in shorter maturity credits also benefit from the roll down effect – the increase in the bond’s price as it approaches maturity and the spread declines.
Adding a short-maturity strategy to a traditional fixed income portfolio can offer diversification benefits, as the returns are less correlated with traditional bond markets. Furthermore, short-dated credits are characterized by a more favorable liquidity profile than their longer dated peers. This attractive liquidity profile, which stems from regular cash flows from maturing bonds, coupon income and the fact that short-dated credits are more often held until maturity, enables a short-maturity strategy to minimize turnover and so reduce transaction costs. This is an especially attractive feature in the current challenging liquidity environment. As with any approach, there are times when a short maturity strategy will be less advantageous. In a scenario of falling interest rates and rallying credit markets, for example, its more defensive nature means that investors will give up some degree of performance as it offers less upside potential at such times.
The Robeco Global Credits – Short Maturity strategy invests in short-maturity global corporate and financial bonds. It is managed against the Bloomberg Barclays Global Aggregate Corporate 1-5 years Index. The core of the portfolio is invested in developed investment grade corporate bonds with a maximum maturity of six years, but up to a maximum of one third of the portfolio can also be invested in emerging credits, high yield (mainly BB-rated paper) and securitized credits to enhance returns while controlling the overall risk profile. It may also hold certain callable securities if these have a call date that is less than six years away.