3 Questions to Ask When Considering Short-Term Bond Strategies
When rates rise, many investors look to decrease their interest rate risk by increasing their allocations to shorter duration fixed income securities. This is due to the inverse relationship between bonds and changes in interest rates: When yields rise, prices decline, and duration is a key indicator of how sensitive securities are to rate changes. However, not all short duration strategies are created equal.
Many short-term bond strategies can incur rapid price declines during periods of extreme market uncertainty due to aggressive positioning in potentially riskier or less liquid securities that may pay additional yield. Recent volatility brought on by rising interest rates, inflation concerns, and geopolitical risks has demonstrated this and should serve as a reminder of the importance of balancing goals of reaching for higher returns while managing risk.
For concerned investors, one solution may be to find an active manager who maintains their short duration position while incorporating a robust risk management process that seeks to protect them during market downturns as well as reward them in more stable environments.
Here are three questions short duration investors should be asking now and how the Natixis Loomis Sayles Short Duration Income ETF (LSST) is addressing these:
1. Is it “Short Duration” in Name Only?
While many short-term strategies seem to promise short duration, some will in fact extend further on the yield curve for additional yield. Extending durations can put portfolios at greater risk of impact from interest rate movements. Increased duration can be beneficial if interest rates fall but can be detrimental to investors and fund performance if interest rates continue to rise.
Total Return vs. Effective Duration for Short-Term Bond Funds (YTD as of 12/31/22)
Source: Morningstar Direct. Past performance is no guarantee of future results.
A strategy’s standard deviation – the measurement of dispersion between performance and mean – can provide a good sense of a strategy’s overall risk level. Some short-term strategies focus on providing a higher yield and will bulk up on riskier, lower-rated securities to do so. In 2022, strategies with larger high yield allocations experienced greater performance volatility on average, indicating a bumpier ride for investors.
Standard Deviation vs. High Yield Allocation for Short-Term Bond Funds (as of 12/31/22)
Source: Morningstar Direct. Past performance is no guarantee of future results.3. Does It Still Pay to Stay in Short Duration?
Throughout 2022, the rate environment has shifted dramatically. The curve has shifted higher and flattened. As a result, investors are not being compensated with additional yield by moving from the front end of the yield curve to the intermediate or long end of the curve. Since short duration strategies typically feature a duration of 1 to 2 years, these products now offer a healthy yield advantage over their duration, which could benefit total returns going forward.
Bloomberg 1-3 Yr Gov/Credit Index Yield to Worst % (YTD as of 12/31/22)
Source: Bloomberg. 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 strategy 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.
Risks: ETF General Risk: Exchange-Traded Funds (ETFs) trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are not individually redeemable directly with the Fund, and are bought and sold on the secondary market at market price, which may be higher or lower than the ETF's net asset value (NAV). Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns. Active ETFs: Unlike typical exchange-traded funds, there are no indexes that the Fund attempts to track or replicate. Thus, the ability of the Fund to achieve its objectives will depend on the effectiveness of the portfolio manager. There is no assurance that the investment process will consistently lead to successful investing. Fixed Income Securities: 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. Below Investment Grade Securities Risk: Below investment grade fixed income securities may be subject to greater risks (including the risk of default) than other fixed income securities. Foreign and Emerging Market Securities Risk: Foreign and emerging market securities may be subject to greater political, economic, environmental, credit, currency and information risks. Foreign securities may be subject to higher volatility than US securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets. Interest Rate Risk: Interest rate risk is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.
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