Short duration bond funds

aroominyork

I looked at short duration credit funds today and was surprised by what I saw. Royal London Short Duration Credit is FE10 and over the last five years has appreciated 19%, the same as Jupiter Strategic Bond but with much less volatility. Jupiter is FE20 and, for my money, is as good a cautious strategic bond fund as there is.

I think I’m going to regret asking this, but is short duration a credible alternative to holding cash or is there an environment where it holds significant downside risk?

masonic

Most of the holdings of that fund are BBB rated or below.

For Government bond funds, in which the risk of default is practically zero, short dated bond funds are considered lower in risk (to hold over a short term) than long dated funds because the main risk in that situation is rising interest rates. For corporate bonds, especially those with a lower credit rating, the risk of default is more significant and short-dated bonds have a greater risk of default than long dated bonds. Even if they do not default, their capital value can fall significantly in the event of unfavourable economic circumstances because of the default risk.

Those of us new to investing need a reality check about the volatility bonds could face. Where can we see that through historic data?

One way to do this is to use Trustnet's interactive charting. Delete the fund of interest, leaving the sector average plot in place (or find a similar fund with a longer history), then zoom out to your crash of choice and see what happened, for example (sector average for strategic bonds):

bostonerimus

If you want to use short duration bond funds to support a cash/savings allocation then make sure they ar investment level corporate or government bonds......you can get great returns with “junk” but there’s also a lot of risk

aroominyork

Masonic, 70% of the fund are BBB or better.

Why do short dated bonds have greater risk of default than longer? Surely it's the opposite which is why their capital return is comparatively low.

The fund sits in strategic bond funds but so does Royal London Sterling Extra Yield Bond which fell over 40% on your chart. The two are chalk and cheese so a sector average doesn't tell much about one or the other.

aroominyork

bostonerimus wrote: »

If you want to use short duration bond funds to support a cash/savings allocation then make sure they ar investment level corporate or government bonds......you can get great returns with “junk” but there’s also a lot of risk

Why is BBB the cut off for investment grade – is it artificial or is there science behind it? Are BB so much worse compared to BBB than A is better than BBB? There seems to be a disproportionately large proportion of bonds rated BBB which seems a little suspicious.

masonic

aroominyork wrote: »

Masonic, 70% of the fund are BBB or better.

As of April 2019:
AAA 5.0%
AA 4.4%
A 21.6%
BBB 39.2%
BB and below 14.9%
Unrated 14.9%

So that's 30% junk (below BBB) and 70% BBB and below. BBB and above is also 70%. BBB is typically considered medium credit risk.

Why do short dated bonds have greater risk of default than longer? Surely it's the opposite which is why their capital return is comparatively low.

Bonds are issued with a final bullet repayment of capital. They are not amortising. Therefore the company must either be able to issue more bonds at an affordable coupon, or have enough capital reserves to repay bondholders at maturity. A company that is struggling may be able to limp along for a while, but an event such as one of their bonds maturing would precipitate an insolvency. As a rule, you don't hold debt-based securities from higher risk borrowers to term. That principle saved Goldman Sachs from much of the fallout of the credit crunch (though their disposal of junk credit was one of the causes).

The fund sits in strategic bond funds but so does Royal London Sterling Extra Yield Bond which fell over 40% on your chart. The two are chalk and cheese so a sector average doesn't tell much about one or the other.

Then find a fund that you think is appropriate. My graph was only an example of how to do this sort of thing for yourself. Look at the performance of RLSEYB vs the sector average, then look at RLSDC vs the sector average. It seems clear that 40% loss corresponds to a 2 x volatility vs the sector average and RLSDC has a volatility more in line with the sector average. This is also reflected in the two fund's beta and FE risk grade. So that all marries up quite nicely.

aroominyork

masonic wrote: »

Bonds are issued with a final bullet repayment of capital. They are not amortising. Therefore the company must either be able to issue more bonds at an affordable coupon, or have enough capital reserves to repay bondholders at maturity. A company that is struggling may be able to limp along for a while, but an event such as one of their bonds maturing would precipitate an insolvency. As a rule, you don't hold debt-based securities from higher risk borrowers to term. That principle saved Goldman Sachs from much of the fallout of the credit crunch (though their disposal of junk credit was one of the causes).

Very interesting. And googling the risk of short-term bonds brought this article which, while it is about gilts/Treasuries rather than corporate bonds, is beyond my level of understanding and makes me think that short duration bond funds fit in the category of "if you don't understand it don't invest in it".

Edit: If there is a principle not to hold bonds to maturity, bondholders wanting to sell them as they approach short duration are not going to find an eager market. That would presumably mean discounting them to offload them. Wouldn’t that mean that a short duration fund manager who knows how to assess the ability of a company to repay at maturity or issue more bonds at affordable coupons, could buy short duration bonds at bargain prices?

A_T

aroominyork wrote: »

I looked at short duration credit funds today and was surprised by what I saw. Royal London Short Duration Credit is FE10 and over the last five years has appreciated 19%, the same as Jupiter Strategic Bond but with much less volatility. Jupiter is FE20 and, for my money, is as good a cautious strategic bond fund as there is.

I think I’m going to regret asking this, but is short duration a credible alternative to holding cash or is there an environment where it holds significant downside risk?

If you want something close to holding cash then you want short term bond funds like the ones Vanguard offer which are mostly A rated and above.

aroominyork

A_T wrote: »

If you want something close to holding cash then you want short term bond funds like the ones Vanguard offer which are mostly A rated and above.

Yes, that's just above cash in risk and return.

This article on the subject was published the other day.

Prism

What I would like to see is an intermediate term (3-7 or 3-10 years) UK bond fund - I don't think there are any. There are for US and Euro bonds (mostly ETFs), but nothing for Gilts that I can see.

I am gradually starting to plan for drawdown and I have the short term part covered with savings accounts but wouldn't mind a bit of local intermediate term stuff, since thats one of the recommendations for a retirement plan

aroominyork

Prism wrote: »

What I would like to see is an intermediate term (3-7 or 3-10 years) UK bond fund - I don't think there are any. There are for US and Euro bonds (mostly ETFs), but nothing for Gilts that I can see.

I am gradually starting to plan for drawdown and I have the short term part covered with savings accounts but wouldn't mind a bit of local intermediate term stuff, since thats one of the recommendations for a retirement plan

How strongly/consistently is that recommended? My current drawdown plan (which is not as many years away as I’d like) is about four years’ of bonds to be split between a mid/high octane strategic fund (eg Man GLG/Sanlam) and a cautious one. I had my eye on Jupiter Strategic for the cautious but if RL Short Duration continues to perform as it has since launch that looks a good option.