Not all short duration is created equal. In the fixed income space, the recent market volatility brought on by rising interest rates, inflation concerns, and geopolitical risks serve as a reminder of the importance to balance investment goals of reaching for higher yield with managing risk.

Many short duration bond funds can incur rapid price declines during periods of extreme market uncertainty and volatility due to aggressive positioning in riskier assets, including below investment grade securities, while others can weather downturns more effectively.

This divergence indicates that the key for investors may be to find an active manager within short duration who seeks to incorporate robust risk management processes to help protect them during market descents and reward them in stable times.

For investors looking to ensure their short-term fixed income strategies are prepared for future uncertainty, here are three questions to consider.

  1. Is it “Short Duration” in Name Only?

    Extending durations in 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 – as illustrated in the graphic below – can be detrimental to investors and fund performance in the event that interest rates rise.

    March 2022 YTD Total Return vs. Effective Duration for Short-Term Bond Funds
    Line of best fit graph showing the total return, YTD of March 2022 in percent on the y-axis versus the fund effective duration on the x-axis. Source: Morningstar Direct, 2022. Past performance is no guarantee of future results.

  2. High Yield, High Risk?

    A strategy’s standard deviation – which measures the dispersion of a fund’s performance relative to its mean – can provide a good sense of a strategy’s risk-adjusted returns. Over the 36-month period ending in March 2022, strategies with larger high yield allocations vs. short-term bond strategies with a more evenly dispersed credit quality mix experienced greater performance volatility on average, indicating a riskier approach to short-term bond investing.

    March 2022 Standard Deviation vs. High Yield Allocation for Short-Term Bond Funds

    Avg. High Yield Allocation (%) as of March 2022
    Avg. St. Dev. (3 yr) as of March 2022
    Top 20 High Yield Allocation Short-Term Bond Funds
    Short-Term Bond Category

    Source: Morningstar Direct, 2022. Past performance is no guarantee of future results.

  3. Is the Strategy Juiced?

    While some short-term bond funds position themselves as basic, diversified fixed income strategies, they may also hold high yield – and higher risk – securities. In times of heightened credit default risk, such as in March 2020 during the Covid-19 shock, short duration funds with an overweight allocation to high yield sustained a harder hit to performance compared to more conservative strategies.

    March 2020 High Yield Allocation and Returns for Short-Term Bond Funds
    Line of best fit graph showing the total return, YTD of March 2020 in percent on the y-axis versus the fund high yield allocation in percent on the x-axis. Source: Morningstar Direct, 2022. Past performance is no guarantee of future results.

Face Rising Interest Rates with a Short-Term Bond Approach

A short duration approach to fixed income investing may alleviate rising interest rate concerns. Add to this disciplined risk management and an active approach, and a short-duration approach may also satisfy various market conditions through the years.

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All 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. Investors should fully understand the risks associated with any investment prior to investing.

Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.

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.

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