Rate rise sparks warning on short duration bond funds

Short duration bond funds may not give investors the protection they seek against rising interest rates, Kames Capital warned investors today.

As short duration funds are usually sold as a form of protection against rising rates, the expected series of US Federal Reserve rate hikes this year may increase the attraction of these funds because their reduced sensitivity to rates potentially minimises capital losses.

Adrian Hull, senior fixed income specialist at Kames Capital, said most investors understand these funds do not remove duration risk entirely, but many – particularly those using them as a cash substitute – may “fail to appreciate the extent of their exposure to rising rates”.

Hull said three-year US treasury notes are a “mainstay” of many short duration funds and would suffer a capital loss of around 1.5% in the event of a 0.5% rise in their yield following a commensurate move in US interest rates.

“With markets firmly of the view that inflationary fiscal stimulus measures are on the way, US interest rates are estimated to rise by 0.5% - 0.75% in 2017 - and short duration funds will be exposed to that.”

He said that when rates moved upwards in the fourth quarter of 2016 three-year treasuries doubled in yield, which will have “left many short duration funds underwater”.

“Markets expect another two or three rate rises this year and you have to ask whether investors would be better off hedging that interest rate exposure and volatility.”

His recommendation to investors was to buy absolute return bond funds, which seek to profit from higher rates. He said these strategies were “much better placed” to address interest rate risk because higher rates can present opportunities in the yield curve which can offset capital losses within absolute return portfolios.

Protection from rising rates is exactly the premise of for JP Morgan Asset Management’s launch of a short duration European bond fund today.

Ashmore Group, an emerging markets specialist, recently promoted its Short Duration Fund as a tactical opportunity and EPFR Global, which provides data on fund flows, noted that most investor flows in emerging market bonds were to short duration strategies recently.

BlackRock’s Richard Turnbull, global chief investment strategist, recently wrote in a paper about 2017 portfolio positioning that the firm favoured shorter-duration bonds given their lower sensitivity to rising rates.

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