Fixed income markets are currently experiencing a rare irregularity. Short-dated bonds are trading at a higher yield than long-dated bonds, in other words, the yield curve is "inverted". For investors in short-dated corporate bonds, this provides a unique opportunity to benefit from some of the most favourable forward looking relative return prospects and attractive valuations in recent history. What this means is the key decision for investors isn't how much duration to take, it's where to position on the curve.
The chart below illustrates historic inversion in the Gilt curve through the spread between 2-year and 10-year Gilts. As we saw in 2022, when inflation accelerates and the Bank of England starts to hike rates, Gilt yields usually rise. Yields at the front end often rise more than the long end in this environment as markets price in expectations for higher rates in the short term, followed by falling rates as growth slows (i.e. the curve "inverts" - see chart 3).
Chart 1: Gilt yields are currently inverted, a rare event in fixed income markets over the past 20 years
Source: Fidelity International, Bloomberg. September 2023. Indices used: GUKG10 Index, GUKG2 Index, UKBRBASE Index.
However, what happens when the reverse occurs, and the Bank of England starts to cut rates? 2-year bonds are the most impacted by any imminent shift in monetary policy as they have the highest sensitivity to near term interest rates. We saw this back in 2008, where the onset of the global financial crisis led central banks to rapidly slash their benchmark interest rates, leading to a substantial rally in the front end of the curve and a significant steepening of the spread between 2 year and 10-year yields.
Whilst short dated bonds typically rally on the back of rate cuts, long dated corporate bonds are influenced only in part by near term interest rates. Future expectations of economic growth and inflation also play a significant role in the pricing and return of these securities as these are the key determinants of future short-term rates. In 2008, for example, the realisation that rates would be close to 0% for an extended period had not yet been fully priced in. As such, the reaction of longer dated bond yields to Bank of England rate cuts was more muted than at the front end of the curve.
We have recently seen one of the fastest rate hiking cycles in history and recent UK growth data and inflation prints are tentatively indicating that its impact is starting to be felt. However, the UK economy is not out of the inflationary woods yet. Brexit and deglobalisation, amongst other supply side shocks, could leave the UK a more permanently supply constrained economy. With productivity also posing a challenge for policymakers, we could see structurally higher inflation in the UK moving forwards.
What does this mean for investors? When looking at where to add duration risk, there is much to be said for having a healthy allocation to the short end of the curve to take advantage of any yield curve steepening. The short end of the curve should rally materially on the back of any near-term rate cuts in the event of a recession providing a near-term capital gain for investors. However, moves in the long end could be more muted, particularly as investors price in concern over a structurally more inflationary UK economy.
Ballast against credit spread widening
Another feature of short dated bonds, specifically corporate bonds, is their relatively low credit risk. Spread duration is a measure which illustrates the sensitivity of a bond's price to a change in its credit spread. Shorter maturity bonds inevitably have lower spread duration than longer dated bonds, but also typically have lower credit spreads, in part because investors have more certainty over an issuer's ability to meet its financial obligations over shorter time periods. As such, investors demand less spread for taking on credit risk in shorter maturity bonds. Currently the spread compensation for taking extra duration is abnormally low. In other words, the credit curve is also "flat" (see chart 2). Creditors are simply not compensated for taking extra duration.
Chart 2: Credit curves are flat
Source: Fidelity International, BofA Indices. September 2023. Indices used: E6L0, EVL0.
Chart 3: Gilt curves are inverted
Source: Fidelity International, Bloomberg. September 2023
Credit spreads often widen around recessions. If this were to materialise, being invested in shorter duration bonds would reduce the price impact of widening spreads whilst benefiting from falling government yields at the front end. This is well reflected in chart 4, which illustrates the return of corporate bonds of varying maturities in the 12 months following the peak of the yield curve inversion, shown for the four previous occasions where yield curves have inverted since 2000. Short dated corporate bonds perform very well against both 5-10 year corporate bonds and 10+ year corporate bonds despite taking less duration risk. This is because of the potential for front-end rates to rally on the back of rate cuts, and the lower credit risk helping ballast against credit selloffs.
Chart 4: Short dated corporate bonds can outperform longer dated corporate bonds, government bonds and equities after peak curve inversion.
Source: Fidelity International, Bloomberg, ICE BofA Indices. September 2023. Indices used: GVL0, EVL0, E6L0, E9L0, ASXTR Index. Total returns calculated as the 12-month returns post peak curve inversion.
Importantly, corporate bond markets can outperform government bond markets during these periods despite the inherent credit risk and accompanying weakness in risky assets. As chart 4 illustrates, during the Covid-19 and early-2000 yield curve inversion, 1-5 year corporate bonds outperformed 1-5 year Gilts, despite these periods being associated with weakness in credit markets. This is because investors earn a premium for owning corporate bonds over government bonds (the credit spread) and this additional income over government bonds can more than offset the losses from wider spreads and defaults.
It should be noted that this was not the case during the Great Financial Crisis, where - despite positive returns from 1-5 year corporate bonds which still outperformed longer maturity corporate bonds and equities - the selloff in credit was so great that short dated government bonds outperformed their corporate bond equivalents. However, it is important to note that credit spreads were tight in the years leading up to the Great Financial Crisis, particularly relative to current levels.
This meant the rise in yields needed to offset the positive carry from holding corporate bonds was lower in the run up to the Great Financial Crisis than would be the case today. As such, we would expect that in less severe market downturns, the excess yield from holding credit, combined with the exposure to front end duration, would support the performance of short dated corporate bonds against short dated government bonds, as seen in previous cycles. This credit exposure needs to be managed carefully, however, and this argument does not hold true with short dated high yield credit.
Set up for success
There has arguably never been a better time to invest in short dated corporate bonds. Investors can take limited duration and credit risk and still have the potential to achieve strong returns, even in a more challenged market environment. With curves starting to steepen, and returns in short dated securities rising, we expect the direction of travel should continue to be positive for short dated corporate bonds from here.
Learn more about the Fidelity Short Dated Corporate Bond Fund
