Capitalising on current opportunities in European short-term bonds
Understanding falling yields in the bond market might seem tricky. Here we explore some of the advantages of investing in short-term bonds.
Autheurs
With a “soft-landing” increasingly forming the base case for investors, demand for duration - the measurement of a bond's sensitivity to interest rate changes depending on when its payments are due - has picked up. This is especially evident with shorter dated maturities: these offer investors a tempting blend of appealing valuations, alongside a high safety margin against capital losses, compared to bonds with longer expiry dates. Moreover, with the commencement of the European Central Bank’s (ECB) rate-cutting cycle, deposit rates on cash savings should decrease, thereby further bolstering bond prices and increasing the attractiveness of bonds relative to cash. Below, we explore the current case for short-dated bonds.
1. Attractive valuations
Fixed income investors have experienced some tough times in recent years, but this has resulted in compelling valuations. In short, this means that the price of some bonds seems favourable compared to the income they are expected to generate, making them potentially good buys.
Additionally, the expectation of lower inflation in the future heightens the attractiveness of fixed income investing, because lower inflation preserves the purchasing power of the fixed interest payments you receive from the bonds, and gives central banks the opportunity to cut interest rates.
Chart 1 shows the Bloomberg Euro Aggregate 1–3 year index, which tracks a wide range of short-term euro-denominated bonds. The yield of these bonds (or the income return on the investment) is currently higher than the 10-year, and even the 20-year, median.
A yield higher than the historical median suggests that bonds are providing a better income return, at a cheaper price, when compared to history. This could represent a particularly fruitful time to invest in these types of bonds, as they could provide larger returns than usual over their lifetime.
CHART1: Yields higher than the 10-year and even the 20-year median
Note: Based on annual returns since 1999 the Euro Aggregate 1–3-year index has outperformed on 20 occasions. Cash has outperformed in only four of those years.
2. Falling yields provide an additional kicker to returns
It's not just about the overall yield you're getting. Timing the peak in yields can be challenging because it involves predicting market trends, and yields have slightly declined from their recent peaks. However, there are good returns to be made when bond yields are falling. When bond yields fall, the price of the bonds often rises. This happens because the fixed interest payment of the bond becomes more attractive compared to the rest of the market.
Bond yields are strongly influenced by interest rates set by central banks and with the ECB embarking on a rate cutting cycle, investors can anticipate a corresponding decline in bond yields (i.e. an increase in price).
In the chart below, we show if you invested at the peak of yields over the past two decades, how returns in short-dated Euro bonds would have easily outperformed cash.
CHART2: Returns if you invested at the peak of yields versus cash returns
Note: Based on history, you don’t need to wait for central banks to actually start cutting interest rates to benefit from falling yields. Short-dated bonds tend to outperform cash over the one and three year periods as soon as rate hikes have ended.
3. The yield cushion should rise
Bond yields represent the overall return to an investor and reflect the income bond holders expect to receive, in the form of regular coupon payments, as well as any potential capital gains. When yields fall bond holders benefit from capital gains (i.e. the price goes up). If yields rise, bond investors can experience some capital loss (i.e. the price goes down), but losses are partially offset by income received.
Before investing it is helpful to understand what level of capital loss might offset income received. This is often referred to as the” yield cushion” and essentially refers to the amount yields can increase before capital losses outweigh the return from income. In summary, the yield cushion offers a safety buffer against loss.
Here's how this works: if you invest in a bond and its yield increases after your investment, the price of the bond will typically fall, which could result in a capital loss if you had to sell the bond immediately. However, if the bond’s initial or current yield is high enough to begin with (i.e. there is a yield cushion), the yield level will – at least up to a point – offset the decline in price, which could prevent a capital loss even though yields have risen.
The good news is that higher yields, even for short-dated fixed income, provide a generous margin of safety against capital losses. This is because even a substantial rise in yields might not outweigh the high starting yield, thereby offering a high margin of safety against capital loss.
The margin of safety ("yield cushion") below, shows how much yields need to rise over 12 months before incurring losses. Currently investors anticipate that the ECB will cut rates, but the margin of safety means European short-dated bonds can withstand up to five to seven 25bp rate hikes before the margin of safety is erased.
CHART3: Yield cushion - High margin of safety against capital losses
Asset classes of the Bloomberg Euro Aggregate Index 1–3 Year, plus Euro High yield (%)
Note: Even short-dated government bonds can withstand a rise of 1.4% before incurring losses – this would correspond to a yield of 4%, and you have to go back to the global financial crisis to see the last time they were at this level.
4. Are we in a soft-landing scenario?
Compelling valuations and buffers are all well and good, but a view on market direction is a key consideration when deciding whether to invest in short-dated fixed income.
Our base case remains a “soft landing,” which means we think central banks have done enough to bring inflation down, but not so much that it breaks the economy. However, we are conscious of rising risks of a “hard landing,” particularly within Europe, where the outlook for manufacturing and services is negative and labour market has shown some signs of weakening. The following chart shows the decline in Euro area Purchasing Manager Indices (PMI) for services and manufacturing and their leading relationship with Eurozone unemployment. While a soft landing is our base case, should the probability of a hard landing increase, the ECB would seek to combat a further slowdown with an accelerated pace of rate cuts.
CHART4: Weaker outlook for Eurozone labour
Note: A “soft-landing” scenario can be good for both government and corporate bonds – driven by a fall in interest rates. In a hard-landing total returns on short-dated investment grade (IG) corporate bonds would also be supported by a fall in interest rates.
5. Compelling cash rates might not be so compelling for long….
With bank deposit rates linked to monetary policy decisions being made at the ECB and other central banks, it’s unlikely that investors will be able to earn similar levels of interest enjoyed over the past couple of years. Furthermore, actual deposit rates earned are often lower than those suggested by central bank rates. By investing in short dated fixed income, you could be locking in this high level of yields for three to five years.
CHART5: The yield you get on short dated fixed income remains higher than most deposit rates
Subscribe to our Insights
Visit our preference center, where you can choose which Schroders Insights you would like to receive.
Autheurs
Topics