Lloyd Harris
Fund Manager, Premier Miton Strategic Monthly Income Bond Fund
For information purposes only. Any views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Investing involves risk. The value of an investment can go down as well as up which means that you could get back less than you originally invested when you come to sell your investment. The value of your investment might not keep up with any rise in the cost of living. Premier Miton is unable to provide investment, tax or financial planning advice. We recommend that you discuss any investment decisions with a financial adviser.
What is duration?
Duration is a measure of the sensitivity of a bond or fixed income portfolio’s price to changes in interest rates. Looking at a quick example, a bond with a 2-year duration will move 2% in price if interest rates move up or down by 1%, a bond with a 5-year duration will move 5% in price if interest rates move up or down by 1%, a 10-year duration bond 10%, a 20-year duration bond 20% and so on. Hence more duration equals more price risk. There has scarcely been a better time not to own duration risk, just look at the shape of the yield curve below. Bonds with a longer-dated to maturity yield an awful lot less than bonds with a shorter-date to maturity.
US Treasuries Activities Curve
Source: Bloomberg data as at 17.02.23
Inversion aversion
As an investor we generally have to pay to take on more risk. Looking at the above chart again, logically, it makes much more sense to own less risk for more return (yield) and invest in bonds with a shorter duration to maturity.
Whilst a yield curve reflects the market’s hypothesis that the Federal Reserve has hiked rates too far and the economy will slow sufficiently to tame inflation, which will lead to lower rates in the future. The market has got this bet wrong for a while.
We do not deny that yield curve inversion does in fact signal recession, but it does not signal when, and as we have seen recently the market could be waiting a long time. Yield curve inversion is when long-term interest rates are less than short-term interest rates. With an inverted yield curve, the yield decreases the farther away the maturity date is, which is the focus of this article.
A much more reliable indicator of recession is when the yield curve starts to price in rate cuts, something it is clearly not doing at present. In the meantime, as fixed income investors we are much better off reinvesting in short-dated bonds when they mature and earning a better yield. We can always add duration risk (bonds with a longer date to maturity) at a later date. We may consider doing this when it becomes clear we have labour market weakness through increasing unemployment figures, leading to less strong wage growth and hence less adhesive inflation.
Keeping it real
Government bonds with a short time to maturity may seem attractive, but short-dated investment grade corporate bonds are even more attractive because they trade with a “spread” or yield in addition to the yield on the government bond.
It is easy to see how at a particular part of the curve, high-single digit returns from relatively safe investment grade rated corporate bonds is achievable, giving investors a fighting chance at a real (inflation adjusted) return, especially when the interest from the bonds is compounded. And all this with potentially lower amounts of price risk because of the focus on shorter duration bonds.
