2023-04-14 17:21:48 ET
Summary
- Is it "short duration" in name only?
- Am I taking on additional risk?
- Does it still pay to stay in short duration?
By Nicholas J. Elward and Tyler A. Williams.
When rates rise, many investors look to decrease their interest rate risk by increasing their allocations to shorter duration fixed income securities. This is due to the inverse relationship between bonds and changes in interest rates: When yields rise, prices decline, and duration is a key indicator of how sensitive securities are to rate changes. However, not all short duration strategies are created equal.
Many short-term bond strategies can incur rapid price declines during periods of extreme market uncertainty due to aggressive positioning in potentially riskier or less liquid securities that may pay additional yield. Recent volatility brought on by rising interest rates, inflation concerns, and geopolitical risks has demonstrated this and should serve as a reminder of the importance of balancing goals of reaching for higher returns while managing risk.
For concerned investors, one solution may be to find an active manager who maintains their short duration position while incorporating a robust risk management process that seeks to protect them during market downturns as well as reward them in more stable environments.
Here are three questions short duration investors should be asking now and how the Natixis Loomis Sayles Short Duration Income ETF ( LSST ) is addressing these :
1. Is it "Short Duration" in Name Only?
While many short-term strategies seem to promise short duration, some will in fact extend further on the yield curve for additional yield. Extending durations can put portfolios at greater risk of impact from interest rate movements. Increased duration can be beneficial if interest rates fall but can be detrimental to investors and fund performance if interest rates continue to rise.
Total Return vs. Effective Duration for Short-Term Bond Funds (YTD as of 12/31/22)
Source: Morningstar Direct. Past performance is no guarantee of future results.
2. Am I Taking on Additional Risk?
A strategy's standard deviation - the measurement of dispersion between performance and mean - can provide a good sense of a strategy's overall risk level. Some short-term strategies focus on providing a higher yield and will bulk up on riskier, lower-rated securities to do so. In 2022, strategies with larger high yield allocations experienced greater performance volatility on average, indicating a bumpier ride for investors.
Standard Deviation vs. High Yield Allocation for Short-Term Bond Funds (as of 12/31/22)
Source: Morningstar Direct. Past performance is no guarantee of future results.
3. Does It Still Pay to Stay in Short Duration?
Throughout 2022, the rate environment has shifted dramatically. The curve has shifted higher and flattened. As a result, investors are not being compensated with additional yield by moving from the front end of the yield curve to the intermediate or long end of the curve. Since short duration strategies typically feature a duration of 1 to 2 years, these products now offer a healthy yield advantage over their duration, which could benefit total returns going forward.
Bloomberg 1-3 Yr Gov/Credit Index Yield to Worst % (YTD as of 12/31/22)
Source: Bloomberg. Past performance is no guarantee of future results.
For further details see:
3 Questions To Ask When Considering Short-Term Bond Strategies