Bond funds – including exchange-traded funds (ETFs)1 and mutual funds – faced a significant test during the early days of the Covid-19 pandemic in March 2020. Several bond funds, especially short-term bond funds which are often considered to be relatively safe investments, disappointed investors due to their rapid price declines. However, over the same period, other short-term bond funds delivered positive results. This divergence indicates that the key for investors may be to find an active manager who seeks to incorporate robust risk management processes to help protect investors during the downturn and seek to reward them in stable times.

As of early December 2020, improved Covid-19 treatments, broader awareness of the importance of mask-wearing and social distancing, and unexpectedly good news around the development of effective vaccines have resulted in cautious optimism that the pandemic can be put in the rearview mirror at some point in the future. There is a light at the end of the tunnel, and it’s not too early for investors to begin considering some post-pandemic lessons. Here’s a list of four post-pandemic concepts to consider in the short-term bond space:

1. Be aware that some short-term bond funds try to “juice” returns by investing in high risk securities. 
While some short-term bond funds position themselves as basic, diversified fixed income strategies, they may also have high yield – and higher risk – securities. The chart below is a name-agnostic list of the Top 20 short-term bond funds that had the largest percentage of high yield in March 2020 and includes their return for that period. As you can see, funds with a high allocation to high yield fell roughly twice as much, on average, as the category average.

March 2020 High Yield Allocation and Returns for Short-Term Bond Funds
March 2020 High Yield Allocation and Returns for Short-Term Bond Funds

  Average High Yield Allocation Average March 2020 Total Return (%)
Top 20 Short-Term Bond Funds by High Yield Allocation
Short-Term Bond Category
Source: Morningstar Direct, 2020

2. Do not just evaluate total returns – consider risk-adjusted returns. 
Large allocations to high yield not only negatively impacted absolute returns, such allocations also led to lower risk-adjusted returns. When assessing the quality of an investment strategy, most investors focus on a fund’s absolute returns versus an index and against peers. Certainly, this is a good start, but it may not go far enough. To get a sense of a strategy’s risk against the index and relative to similar strategies, investors can consider the amount of risk it takes on as measured by standard deviation. A strategy’s Sharpe Ratio can give you a good sense of a strategy’s risk-adjusted returns. It calculates how much excess return an investor receives for the extra volatility inherent in a riskier asset.

Over the 12-month period ending in October 2020, the 20 funds in the short-term bond category with the highest Sharpe Ratios all had modest high yield allocations. In addition, their Sharpe Ratios tended to be much higher than the category average. As a result, high yield allocations did not overwhelm fund performance during the Covid-19 pandemic sell-off. This suggests that a significant tilt towards risk assets may not be worthwhile as investors ready portfolios for the road ahead while remaining mindful of any next potential sell-off.

March 2020 High Yield Allocation and Sharpe Ratio for Short-Term Bond Funds
High Yield Allocation and Sharpe Ratio for Short-Term Bond Funds

Source: Morningstar Direct, 2020

3. Watch out for funds that extend duration in an attempt to post stronger returns. 
Extending durations is another way in which some short-term bond funds can put investors at greater risk. Put simply, going out further in maturity can expose investors to more interest rate risk. Increased duration can be beneficial if interest rates fall, but can be detrimental to investors in the event that interest rates rise. As the chart below indicates, several short-term bond funds had nearly 50% higher duration than the category average as of March 31, 2020. (As a general point of reference, a 1% increase in interest rates on a fund with a duration of 4 will see its value fall by 4%.) Investors who purchased these short-term bond funds likely were not expecting to be exposed to so much interest rate risk. This becomes an important factor to consider when weighing the direction of interest rates in a post-pandemic environment.

March 2020 Duration and Returns for Short-Term Bond Funds
March 2020 Duration and Returns for Short-Term Bond Funds

  Average Effective Duration, March 2020 Average March 2020 Total Return (%)
20 Highest Duration Short-Term Bond Funds
Short-Term Bond Category
Source: Morningstar Direct, 2020

Past performance is no guarantee of future results. Index returns are not intended to imply any future performance of any investment product. It is not possible to invest in an index.

4. Understand the short-term bond strategy’s risk management process.
A more rigorous risk management approach is likely to incorporate tactics that include scenario analyses of past market environments and beta analytics around sensitivities to yield curves and spreads. A review of how each holding contributes to the risk profile of the larger portfolio can also be conducted. A full understanding of how a strategy seeks to calculate risk is important in determining how it can help achieve an investor’s long-term financial goals. 

Final Thoughts
As of late November, markets are calmer than they were at the onset of the Covid-19 crisis. Despite positive news around vaccine developments, public health and economic challenges related to the pandemic are likely to remain over the short term. Now may be a good time for investors to reevaluate their risk positioning in short-term bond funds. The world will eventually move on from the pandemic, but the importance of principal protection and risk management will remain.
Exchange-traded funds (ETFs) trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than the ETF's net asset value. Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns. Active ETF: Unlike typical exchange-traded funds, there are no indexes that an active ETF attempts to track or replicate. Thus, the ability of an active ETF to achieve its objectives will depend on the effectiveness of the portfolio manager. Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns.

Investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.