We believe short-dated sterling corporate bonds offer a compelling opportunity in the current uncertain landscape, and make the case for why now could be an especially opportune time to consider an active approach in this asset class.

Protection from volatility?

Short-dated corporate bonds in sterling are broadly defined as securities with a maturity of up to five years, issued by companies with an investment-grade (IG) rating. With an investable universe of around £150 billion, the market is well developed and includes bonds issued by a wide range of sectors, countries and companies. 

The short maturities of these bonds mean the average duration (interest rate risk) is lower than the broader IG bond market.  This duration profile means returns from short-dated credit are less sensitive to moves in interest rates and gilt yields, especially during periods of interest rate volatility. Looking back at 2022 for example, which saw 13 rate hikes from the Bank of England, short-dated bonds outperformed the sterling corporates index (consisting of bonds across various maturities) by almost 12%.

From a credit perspective, company cashflows and earnings are generally more predictable over a two to three year timeframe than over longer periods. This typically means tighter credit spreads (i.e., the yield premium versus government bonds or “risk-free” rates) for short-dated bonds. However, there are now many cases where issuers’ short-term credit spreads are flat relative to, or wider than, their longer-term debt. This partly reflects near-term expectations of recession and earnings downgrades, which could make it harder for some companies to refinance or meet their near-term debt maturities.

However, we believe this presents potential opportunities in some sectors (such as real estate), and issuers where risk premiums are less warranted. An active investing approach can look to benefit from these anomalies and target attractively priced bonds at shorter duration parts of the curve, while taking controlled duration and long-term credit risk.

An opportune time to invest?

Lower duration, an upward sloping yield curve and tighter credit spreads have traditionally made short-dated bonds more expensive than the broader universe. Historically, short-dated credits have traded at a yield 0.75% lower, on average, than the sterling all maturity index¹. Today, however, as shown below, short-dated bonds now offer an increase in yield of around 0.40%:

After ten years of trading at a premium to the corporate index, it is now possible to achieve the same (or higher) yields in short-dated corporate bonds as in all-maturity corporates, but with around less than half of the interest rate risk.² As such, we think this can be a useful way for investors to boost their returns versus cash (without a material sacrifice in credit quality), or to maintain an attractive yield and credit spread, with enhanced protection from interest rate volatility.

Balancing risks and opportunities via an active approach

With a more concentrated opportunity set in the short-dated space, we believe it is crucial to be selective in issuer and sector allocations. For example, bonds from financial issuers represent a relatively high (over 60%) proportion of the short-dated universe. Banks, in particular, have issued significant amounts of bail-in-eligible senior debt in recent years, to build up their regulatory capital buffers, with the vast majority of this sterling issuance maturing in less than ten years. As such, at £74 billion, the banking sector now represents over 50% of the short-dated index, having grown from 36% only five years ago³:

The recent turmoil in the banking sector - first with Silicon Valley Bank in the US and latterly in Europe with the demise of Credit Suisse – reinforces the advantages of being selective with sector and issuer concentrations in portfolios. We believe that having active flexibility to choose investments across the capital structure, in different currencies or even high-yield opportunities sometimes, can help improve diversification and deliver better risk-adjusted returns.

In addition to managing sector and issuer selection, an active investing approach can utilise off-benchmark exposures across the maturity spectrum. For example, we see value at present in holding bonds with less than one-year to maturity to improve liquidity. This approach allows a consistent run-off of maturing bonds to build up cash, or for the purpose of reinvesting in opportunities further out the curve. Importantly, it also limits trading costs by not needing to sell or give up yield when bonds roll off benchmarks below one-year to maturity. Similarly, an active approach can enable selective participation in bonds longer than five years to maturity, without needing to wait for index inclusion.

Is it time to power up portfolios by diversifying into corporate bonds?

After a difficult 2022 for bond markets, credit spreads in sterling are tighter so far this year, despite the recent stresses seen in the US and European banking sectors. Markets are likely to remain volatile in the near-term amid still elevated inflation and heightened risks of recession.

In this kind of environment, we believe short-dated credit can act as a potential “safe haven” by protecting against volatility, while also benefitting from attractive yields and retaining scope to benefit from economic upsides and/or changes in monetary policy cycles. Given the dispersion of credit spreads and the range of idiosyncratic opportunities now available, we believe an active approach in short-dated credit is well-suited for navigating the current uncertain environment.