At a time when cash deposits are yielding virtually nothing, many institutional and retail investors have looked to short duration bond funds as a way to boost the yield on the portion of their savings they want to keep safe. However, while short duration bonds are a relatively safe option for investors, they are not necessarily a perfect substitute for cash as they can exhibit some volatility (up and down movements in price) at times. So while they can be recommended for longer term cash they are not appropriate for shorter term cash holdings.
Short Duration Bonds an Alternative to Deposits
Short duration bond funds typically invest in bonds that mature in 1–3 years i.e. the issuer fully repays the capital on a specified date within that time frame. Funds investing in short duration bonds will typically buy both government and corporate bonds with the mix varying over time depending on market conditions and other factors. However, the lowest risk short duration bond funds will buy only investment grade bonds from very strong issuers and will buy few if any high yield or junk bonds. A typical short duration bond fund may hold 100 or more different bonds.
Risk
Since short duration bond funds tend to be lower risk, many investors use the funds as a higher-yielding alternative cash. While cash is generally classed as the lowest risk option on the income risk-reward spectrum, short duration bond funds are considered to be the next step up the ladder in terms of both risk and return potential. The limited amount of time until maturity means that interest rate risk—or the risk that rising interest rates will cause the value of the fund’s principal value to decline is low compared to other asset classes such as equities and even longer term bonds. That said, even the most conservative short duration bonds funds will have a small degree of price fluctuation. Aside from the interest rate risk, there is also the default risk i.e. that the issuer will not be able to repay on maturity. This risk is mitigated by a high degree of concentration in investment grade bonds where the risk of default is minimal. In addition the large number of bond holdings within the fund will also dilute the impact of a default in the unlikely event that one should occur.
Yield Advantage
Short duration bond funds can offer a decent yield advantage relative to cash—anywhere from 0.5%–2.0%, depending on their underlying investments—and this can add up over time. As a result, many investors who are in a position to take on the added risk of short duration bonds can allocate a portion of their portfolios to the asset class as an alternative to keeping cash in a bank deposit. However, if there is a likelihood that the cash will be required within 12 months or less, or if the investor has an extremely low tolerance for any risk, a cash deposit is still the better option.
How to Invest in Short Duration Bonds
Investors who want to allocate some of their portfolios to short duration bonds are best advised to purchase a fund rather than seek to buy individual bonds. There are a large number of such funds on the global market, including both actively managed funds and ETFs. However, many of these funds are dollar denominated. Euro based investors will have a narrower range to choose from although the options are still numerous. All of these funds are highly liquid and are traded daily, meaning that the investor can exit a fund the day after they buy should they choose to do so.
Harvest’s approach to investing in short duration bond funds
Following an in-depth examination of the sector, Harvest has selected a small number of short duration bond funds which we feel are most appropriate for our client base. However, we would also stress that investing in one or more of these funds should be
done in a proper portfolio context and that your first step should be a conversation with your client advisor. This should then allow for your own individual circumstances and risk disposition and should result in an optimal outcome each individual client.
To find out more about Short Duration Bond Fund and determine if they would be a suitable and appropriate investment in your portfolio, please speak to your Client Advisor, call us on 01 237 5500 or email justask@harvestfinancial.ie.
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