Bond navigators: Does the short end have a long future?

Assessing fixed income markets this year, we can see two clear trends that matter for credit investors.

First, we’ve seen curves go much steeper – the short end helped by central banks cutting rates and pulling down short-dated government bond yields, while long-dated government bonds have suffered due to higher government borrowing and elevated long-term inflation expectations.

Second, credit spreads have tightened – demand for credit is still very high and companies are in pretty good shape, having borrowed sensibly (on the whole) during a period of low rates.

As a result, short-dated credit has been a solid investment allocation for many investors. This year, sterling short-dated credit has returned just over 4%*, helped by falling underlying yields and tighter credit spreads. As ever, when an asset class has done well, it is sensible to ask: does this continue?

Short-dated credit has been a solid investment allocation for many investors.

I think it does – and in my view, weighing those same factors supports this stance. For government bonds, long bond yields are not being driven by economic fundamentals, so much as the fact that governments are not doing anything to address deficits. As a result, politicians haven’t yet learned that you can only borrow if you have a willing lender. If governments don’t address those deficits, investors will remain reluctant to lend to them for the long term.

However, the short end should remain anchored by the view that interest rates will fall – with the US, eurozone and UK all widely expected to fall over the next 12 months with the market pricing in near-zero chance of rate hikes. Meanwhile, with  credit spreads near all-time tights, there may be little prospect of lower spreads, but while economic growth is somewhat anaemic, the risk of a recession that would see companies fail to meet coupon payments and hence spreads to widen, feels remote.

In my view therefore, with its fortunes tied more to fundamentals, the short end of the market is easier to predict. At the same time, long-dated bonds are a hostage to political fortunes and even if they look cheap, interest rates could continue to rise if there is no political will to cut spending and the investor buyer strike continues. Short credit could remain attractive for a while yet.

*ICE  ML BoA Sterling Non-gilt 1-5 year index, 1 Jan – 31 August.

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