US policy is injecting a new level of uncertainty into the global outlook. Volatility is up across all financial assets, and bonds have not escaped. So, how are short term bonds holding up? The “short” answer is: pretty well – by James Ringer

In a world where a news headline or a tweet can shift markets rapidly and significantly, short dated bonds have offered a degree of comparative stability year-to-date.

It’s most obvious in eurozone markets, where a more protectionist US has corresponded with a seismic shift in the German fiscal landscape, driving longer dated bond yields higher.

The chart below compares the performance of the Bloomberg Euro Aggregate Index (composed of government bonds, credit and securitised) in the 1-3 year sector with the +10 year sector.

As you can see, the much smoother appreciation of the short dated bond market year-to-date is in contrast to the considerably higher volatility and underperformance of longer maturity bonds.

But it’s not just eurozone markets – it’s a similar story in the US and the UK as well. Here too, longer maturity bonds have underperformed and exhibited – as we would expect given the higher level of interest rate risk – greater volatility.

Yield curves have steepened

A lot of the outperformance of short dated bonds year-to-date has been attributed to the steepening of yield curves. Yields have fallen in the shorter end of the curve – as central banks maintained their easing bias – and in most cases have risen in the longer end of the curve, as the term premium* has increased.

As we know, yields move inversely to price, so as illustrated below, the year-to-date price return of the 1-3 year sector was positive, with an additional coupon return boosting the overall total return.

In comparison, the +10 year sector saw total return losses as the (albeit higher) coupon return was insufficient to offset the losses from rising yields.

The stability effect of income

However, despite the recent steepening, curves remain pretty flat from a historical perspective, which means investors gain comparatively attractive yield, for a lot less duration (or interest rate risk).

With the Zero Interest Rate Policy (ZIRP) days now behind us, income has thankfully once again become a more significant part of bond returns. While this is true whichever maturity you’re looking at, the much lower duration associated with short dated bonds means this steady income stream is a greater proportion of this sector’s total return stream.

Put another way, the buffer or protection from capital losses for short dated bonds is greater as the yield per unit of interest rate risk is higher.

This is illustrated in the chart below, which shows the breakeven levels (the move in yield required to wipe out the return from income over a 12 month period) comparing short and long dated eurozone bond markets.

We’re not saying that this section of the curve won’t incur losses, but the higher the breakeven, the more protection you have.

Where do we go from here?

We may be at peak uncertainty – or we may not. What we can say with certainty is that short dated fixed income has a strategic role to play in a broader investment portfolio.

As cash rates fall, short dated fixed income can offer the stepping stone investors are looking for to move out of cash or diversify a broad portfolio of investments in order to reduce the volatility of returns. The consistent level of income now – as it did in the past – helps to limit market volatility, which is particularly useful when the economic outlook has the potential to switch at a moment’s notice.

Given the current environment, it’s important to remember that it’s no longer as simple as just buying bonds and investors need to mindful of curve positioning as well as divergence by geography and asset class. That’s why an actively managed short dated bond fund ticks many of the boxes for investors looking to diversify the risk of their portfolio, particularly one that has the ability to react quickly to a changing and challenging market environment.

_{* Term premium is this additional return (yield) you receive for taking on the extra risk of locking your money away for, say, ten years compared to reinvesting cash in risk-free securities as they mature multiple times, such as one-month bills for ten years.}