Short duration bond funds not the answer to rising rates, says Kames Capital

London – Fixed income investors seeking to protect themselves against rising interest rates in 2017 should fully understand the limitations of short duration credit funds before they buy them, says Kames Capital.
With the US Federal Reserve expected to hike rates by up to 0.75% this year, investors are increasingly seeking ways to minimise their exposure to potential capital losses through less interest rate sensitive strategies such as short duration bond funds.
However, Adrian Hull, senior fixed income investment specialist at Kames, says that while most investors understand that these funds do not remove duration risk entirely, many – particularly those using them as a cash substitute – may fail to appreciate the extent of their exposure to rising rates.
“Short duration credit funds will have less exposure to rates markets than their longer duration cousins, but they cannot completely remove it,” he says. “With markets firmly of the view that inflationary fiscal stimulus measures are on the way, US interest rates are estimated to rise by 0.5% – 0.75% in 2017 – and short duration funds will be exposed to that.”
Hull points out that three-year Treasury notes, a typical mainstay of many short duration funds, would suffer a capital loss of around 1.5% in the event of a 0.5% rise in their yield following a commensurate move in US interest rates.
“When rates went up in the fourth quarter of 2016 three-year Treasuries doubled in yield, which will have left many short duration funds underwater,” he says. “Markets expect another two or three rate rises this year and you have to ask whether investors would be better off hedging that interest rate exposure and volatility.”
Hull says absolute return bond funds, by seeking to profit from higher rates, are much better placed to address the inherent risks which affect short-dated bond strategies.
“Higher rates can present opportunities in the yield curve which can offset capital losses within absolute return portfolios,” he says. “For example, we will select high quality short-dated corporate bonds within our Absolute Return Bond Global Fund, but we will also use global cash and derivative bond instruments to implement paired or hedging strategies to protect the portfolio in different market conditions.”
The fund, which is typically managed within a 0-1 year duration range, demonstrated how this approach can reduce volatility and correlation to interest rate markets during the Trump election in November 2016. While short duration bond funds experienced varying levels of drawdown due to their market directionality, the Kames fund eliminated the effects of the market reaction and generated a positive return.
“Political uncertainty has been a dominant factor in 2016 and this year promises to offer further potential credit risk events,” says Hull. “Investors will have to navigate, for example, elections in Europe (including Germany and France), a Trump presidency with potentially new policy measures, and Brexit negotiations in the UK.
“Spread product is likely to have a solid year, but in this environment it is likely that markets will be volatile. Short-duration credit funds will get some of this benefit – but they may not offer investors as much protection as they aim to.”