IN FOCUS6-8 min read

Could short-dated bonds provide an attractive alternative to cash?

Is it time to trade your cash for short-dated fixed income? The shift could be a multi-decade opportunity for savvy investors.

20/03/2024
Empire State Building

Authors

Karen Wright
Associate Investment Director, Global Unconstrained Fixed Income
Michael Lake
Investment Director, Fixed Income

In this piece, we delve into the world of bonds with shorter maturities and their potential to offer a stable, less volatile alternative to cash.

When we discuss short-dated fixed income, we're referring to bonds with shorter maturities, typically up to around three or five years. Due to their lower sensitivity to interest rate fluctuations, these bonds tend to be less volatile than their long-dated counterparts, making them an attractive option for investors contemplating a move away from cash. But that’s not the only reason to consider them now.

1. Short-dated bonds offer attractive valuations

The past few years have been challenging for bond investors, with high volatility keeping investors up at night and rapidly rising interest rates causing prices to tumble. But this has also created a unique opportunity. Fixed income investors can now benefit from significantly higher yields. The Bloomberg Euro Aggregate 1–3 Year Index, for example, now boasts yields above both the 10-year and 20-year medians.

CHART1: Valuations are currently looking attractive

line chart

Note: Based on annual returns since its inception, the Bloomberg Euro Aggregate 1–3-year index has outperformed cash on 20 occasions. Cash has outperformed in only 4 of those years.

2. The economic backdrop is supportive

Falling yields (yields move inversely to price) could provide an additional 'kicker' to bond returns. Our Global Unconstrained Fixed Income team’s base case is a 'soft landing', where central banks successfully curb inflation without damaging the economy. This environment should benefit both government and corporate bonds as interest rates fall and businesses are generally proving resilient.

Expectations are high for the European Central Bank (ECB) and other central banks to start cutting rates in the coming months as inflation pressures ease. A reduction in interest rates typically leads to an increase in bond prices, with increased demand for existing bonds with higher fixed coupons leading to an increase in prices. Lower interest rates also support business conditions, with lower borrowing costs making it easier for companies to pay coupons to bondholders.

CHART2: The progress on European inflation has been relatively good

line chart

3. The protective yield cushion - putting the 'income' back into fixed income

Higher yields in short-dated fixed income now provide the best safety margin against capital losses in years. This “yield cushion” is the protective effect that this income can have on a bond investment. If bond prices fall (which would result in a capital loss if the bond were sold), the income generated by the bond can offset some or all of this loss. In other words, the yield provides a "cushion" against declines in the bond's price.

The yield cushion is particularly important for investors concerned about capital losses.

This chart is based on the Bloomberg Euro Aggregate Index 1-3 year.

CHART3: The yield cushion is providing the highest margin of safety against capital losses for many years

bar chart

Note, the margin of safety (or yield cushion) is how much yields need to rise over 12 months before incurring actual losses.

4. Cash rates may lose their appeal

With deposit rates closely linked to monetary policy, the attractive interest rates on deposits enjoyed over the past year may not last. In fact, actual deposit rates are often already lower than those inferred by central banks. According to ECB data, the average deposit rate (redeemable at notice) is just 1.7%. By investing in short-dated fixed income, investors can lock in higher yields, as demonstrated in the chart above, for a longer period.

CHART4: Deposit rates are likely to fall. The yield you get on short dated fixed income is already higher than most deposit rates.

line chart

Authors

Karen Wright
Associate Investment Director, Global Unconstrained Fixed Income
Michael Lake
Investment Director, Fixed Income

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