Benefits of Short Duration in Times of Rising Rates

A short-term investment approach may prove useful in the current environment.

Tatiana Grayle-Castro, Portfolio Manager

MUZ - Tatiana Grayle-Castro
Tatiana Grayle-Castro

Given the pervasive impact of bond rate changes and growing recession worries, we believe that a short-term approach to investing could prove useful in the current environment. Short-term bonds usually offer benefits that can protect investors during extended periods of volatility and rising interest rates.

Less sensitivity to rates and duration of spreads

The transition to higher interest rates has begun. While markets have largely priced in higher interest rates by the US Federal Reserve and the European Central Bank, the risk of yields rising further may be more related to widening credit spreads. Under these conditions, short-term bonds may provide better protection against rate hikes because they are less sensitive than their longer-term counterparts.

Low Volatility Potential: Nominal Pull Effect

Short-term corporate bonds tend to exhibit less volatility than their long-term counterparts. Short-term bonds rarely trade below par, and when they do, their value tends to rise rapidly. They also tend to converge towards par as they approach maturity. This is known as the “pull-up to par” effect, which allows short-term bonds to offset losses.

Benefit of “rolling down” on the yield curve

The “rolling down” effect aims to maximize the yield of a bond by exploiting the shape of its curve. Thus, when the yield curve is positive, as a bond matures and therefore “falls” down the curve, its yield decreases but its price increases (yield changes inversely with price). This characteristic is especially true for short-term bonds, since the yield curve is usually steeper at the short end. Therefore, the positive effect of downward winding may be greater than for longer-term bonds.

Transfer source

For short-term bonds, carryover is also a source of income. Carry allows you to compensate for a fall in the price of a bond. As prices fall, carry increases. The higher the carry, the more negative price movement can be offset by a larger carry.

Worst behind? It seems so

What does this mean for investors? Considering only the pass-through element, if we saw interest rate hikes and spread widening like the last 6 months, bonds would not suffer the same level of losses. In our opinion, the worst is over. The first half of this year has been particularly painful as we started with a low carry, a market with negative returns and no protection, followed by a sharp drop in price. Today, the transfer is gradually offsetting the observed decline in prices. If prices continue to fall, the carry will increase and offset this development.

Short duration for better performance

In our opinion, today’s situation is different from what it was at the beginning of the year. For short-term strategies, carry-over, par-leveling, winding down, as well as active management can provide volatility protection and should support stronger results in the second half of 2022 even in challenging macro conditions.

Muzinich & Co. referred to herein is defined as Muzinich & Co., Inc. and its branches. This material has been prepared for informational purposes only and therefore any opinions contained therein should not be construed as investment advice. Opinions are as of the date of publication and are subject to change without notice. Past performance is not a reliable indicator of current or future performance and should not be the only factor to consider when choosing a product or strategy. The value of investments and income from them can both decrease and increase, and is not guaranteed. Exchange rates can cause the value of an investment to rise or fall. Emerging markets may be more risky than more developed markets for a variety of reasons, including but not limited to increased political, social and economic volatility, increased price volatility and reduced market liquidity.

All research contained in this document has been obtained and may be used by Muzinich for its own purposes. The results of this study are provided for information only and their accuracy is not guaranteed. Opinions and statements about trends in financial markets based on market conditions constitute our judgment and such judgment may not be correct. The views and opinions expressed should not be construed as an offer to buy or sell or an invitation to any investment activity, they are for informational purposes only.

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