Using short duration as a liquidity tool

  • 27 May 2024 (5 min read)
KEY POINTS
Short duration bonds may be an option for investors looking to enhance performance of their liquidity portfolios.
Why the characteristics of short duration bonds make them a potential bridge between cash and longer-term fixed income investments.
Short duration bonds should benefit from the fall in sovereign yields on the back of lower interest rates.

For investors with large cash balances following the recent period of high interest rates, it may be time to start considering how the liquid allocation within their portfolio is positioned with rate cuts on the horizon. There is a case for considering short duration bonds for those investors looking to enhance performance of their liquidity portfolios while mitigating risk.

Short-dated bonds – A compelling alternative to enhance cash returns

Short-dated bonds typically have maturities up to five years, making them a potentially suitable bridge between cash holdings and longer-term fixed income investments. While riskier than cash, the higher returns on offer, limited volatility and natural liquidity of short-dated bonds should make them an attractive consideration for the liquid part of an investor’s portfolio.

There are key characteristics of short-dated bonds that make them particularly suited for liquidity management.

  • Low volatility: Short-dated bonds tend to exhibit much lower price volatility compared to their longer-term counterparts, making them an attractive option for cash liquidity strategies.
  • Natural liquidity pipeline: As short-dated bonds mature, the principal is returned to the investor, creating a natural liquidity pipeline. This reduces the need to trade and incur additional costs, further benefiting portfolio performance.
  • Pull to Par: In environments where bonds are trading at a discount, the pull to par opportunity – where bonds are redeemed at their face value upon maturity – is attractive. This can potentially enhance returns, even when central bank rates are rising.

Reasons for short duration

The inversion of sovereign yield curves, flat credit curves and continuing attractive yield valuations mean we continue to see opportunities in short duration strategies. As shown in the chart below, by investing in short duration strategies you should be able to minimise your duration risk while maximising your yield.

Sovereign Yield Curves
Source: AXA IM, Bloomberg as of 30 April 2024

Short-dated bonds have proven their resilience over this hiking cycle, providing much better returns when compared to longer duration strategies. As we’ve now reached the peak of this hiking cycle, central banks may start cutting interest rates which should lead to falling cash rates. As such, there is an opportunity cost to remaining heavily invested in cash as short-dated bonds should outperform it by benefitting from the fall in sovereign yields on the back of lower interest rates. 

Moreover, opting for active management offers additional advantages such as default risk mitigation, avoiding forced sales, and the potential for yield enhancement through careful bond selection. By considering short-dated bonds as part of a cash liquidity strategy rather than a traditional bond allocation, it may help investors optimise their portfolios and navigate the complexities of the current financial landscape.

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