frankfort

Short-duration eurozone bonds: Why invest in EUR credit amid interest-rate uncertainty?

Short-duration bond management is intended for both retail and institutional investors who are seeking exposure to the short end of the yield curve (0 to 5 years), either as a structural allocation that aims at outperforming money-market returns with limited risk, or as a tactical retreat from riskier assets.

In this document, Benjamin Le Roux and Frédéric Penel, who together comprise the Euro Short Duration team, explain their approach to this asset class.

The benefits of short-duration bonds

Against a backdrop of low interest rates and high uncertainty stemming from the US-Chinese trade war, Brexit, the German coalition’s future and the Italian government’s decisions, finding a low-risk alternative to negative returns on money-market instruments may seem tricky.

Since the ECB’s dovish policy on interest rates may be followed by a series of rate rises when the business cycle enters its final phase, investing in short-duration bonds is one way of maintaining exposure to the credit market and the higher yields it offers, while adopting a cautious stance.

A well-suited strategy to uncertain conditions

The success of a short-duration investment strategy depends on the active management of the portfolio’s duration, credit quality and maturity breakdown.

The duration of a bond represents the sensitivity of its price to changes in interest rates. Short-duration bonds are inherently less exposed to changes in interest rates than bonds with longer durations or maturities. Exposure to interest-rate risk may be limited by actively managing duration over time.

It is also possible to seek exposure to a rise in interest rates by positioning a bond portfolio’s duration below 0.

A short-duration portfolio outperforms money-market returns with limited risk, provided that default risk is minimised through effective diversification across issuers and by investing primarily in investment grade bonds.

Our short-duration strategy

Our investment process is characterised by active, cautious and flexible management of interest-rate risk and credit risk, with the objective of outperforming a short-term Euro Investment Grade credit index over a one-year horizon.

With this aim, we primarily select investment grade euro-denominated bonds with durations that range from less than 1 year to 5 years.

To diversify risk, we track about 120 positions on average. The investment process draws upon the following performance drivers:

Our Euro Short Duration expertise involves several distinct strategies:

  • Active management of interest-rate risk exposure by varying duration from -2 to +5
  • Low exposure to high yield and unrated securities
  • Opportunistic allocation to various types of debt securities.

The portfolio may include both fixed- and floating-rate securities. Credit duration is managed independently of interest-rate duration. We may increase or hedge our interest-rate exposure by using futures contracts on 2- and 5-year German interest rates traded on Eurex.

We believe that a short-duration strategy that implements these performance drivers provides cautious and diversified exposure to bond markets while enabling rapid responses to shifts in the interest-rate environment.

Risks associated with this asset class

  • Credit risk: The risk of a potential downgrading of an issuer’s credit rating, or in an extreme case its default, which would decrease the price of the issuer’s securities.
  • Liquidity risk: The risk that a lack of liquidity in an underlying market will substantially increase the market’s price volatility in response to large trades.
  • Derivatives risk: The use of derivatives may amplify the risk of loss.

Useful concepts and definitions

  • Maturity: Maturity, or more specifically residual maturity, is the time between the issuance date of a debt security and the date at which its principal is repaid. The term ‘tenor’ is also used.
  • Duration: The duration of a debt security reflects the sensitivity of its price to a change in interest rates. A bond’s price moves inversely to a change in interest rates. When interest rates rise, issued bonds become less attractive since they yield less than the market’s current yield. Conversely, falling interest rates will increase the price of issued bonds since their coupon rate exceeds the current market rate.
  • Duration as a measure of the impact of a change in interest rates: Practically speaking, when a bond has a duration of 5 years, its price will increase about 5% with each 1% decrease in the interest rate. Conversely, this means that if the interest rate rises 1%, the bond’s price will decrease about 5%. Duration enables investors to easily determine and compare the interest-rate sensitivities of bonds that have different maturities and pay different coupon rates. For example, a bond with a duration of 6 years should normally be twice as sensitive to a change in interest rates than one that has a duration of only 3 years, regardless of their maturity dates or coupon rates.

Information

September 2019. Photo credits: Shutterstock

Notes : These analyses or descriptions may be subject to interpretation depending on the methods used. The opinion expressed above is dated late August 2019 and is subject to change. Most recent data at the date of publication.

This document has no pre-contractual or contractual value. It is provided to its recipient for information purposes. The analyses and/or descriptions contained in this document should not be interpreted as advice or recommendations on the part of Lazard Frères Gestion SAS. This document does not constitute a recommendation to buy or sell or an investment incentive. This document is the intellectual property of Lazard Frères Gestion SAS.

Any management method presented in this document does not constitute an exclusive approach of Lazard Frères Gestion SAS, which reserves the right to use any other method it deems appropriate. These presentations are the intellectual property of Lazard Frères Gestion SAS.

In addition, some services and/or investments included in this document may present particular risks and are not necessarily suitable for all investors. It is therefore the responsibility of all persons to independently measure the risks associated with these services and/or investments before any investment is made. All investors are required to refer to the conditions proposed by Lazard Frères Gestion SAS to its clients relating to the services and/or investments contained in this document.

LAZARD FRERES GESTION – S.A.S with a capital of 14.487.500€ – 352 213 599 RCS Paris

25, RUE DE COURCELLES – 75008 PARIS


-- PDF --