After a multi-decade rally in government bonds, yields have hit historic lows as investors piled into the asset class for safety given the poor economic backdrop. However, many industry experts now believe the global economy is in recovery mode, which is likely to see interest rates and yields on government bonds rise.
This would lead to a fall in the price of bonds, with long-duration credit the most affected.
Trindade, who manages the AXA Sterling Credit Short Duration Bond fund, says investors need to protect themselves against this.
The manager warns that investors have the tendency to wait until after an event has happened before they act.
"We have seen a bull rally in government bonds over the last 20 to 25 years," he said.
"Back in the 1990s, government bonds were yielding 12 per cent, now it is around 1.9 per cent. When yields were higher, investors didn’t look into duration; why would they? But now with yields at 1.9 per cent, there is more of a chance they will rise."
"When investing their clients' money, advisers cannot be fully invested in equities as they need diversification."
"However, with government bond yields at such low levels, the only way is up and that is where short-duration credit comes in," he added.
Trindade highlights the impact of a rise in government bond yields on the total return of an average sterling corporate credit bond – with duration of 8.4 and a yield of 3.7 per cent – against the average sterling corporate short duration credit bond – with duration of 2.2 and a yield of 2 per cent.
"If government bond yields were to rise by 50 basis points, an all-maturities corporate bond would see an annual negative return of 0.5 per cent while the short-duration credit would still make 0.9 per cent."
"If there was a 1 per cent increase in government bond yields, the short-duration credit would lose 0.2 per cent, but the all-maturities credit would lose 4.7 per cent. This is why we are explaining to investors why they need to focus on short duration in the current environment," he added.
Impact of rise in government bond yields
| Govt. bond yield increase by | 1% | 0.75% | 0.50% |
|---|---|---|---|
| Short duration credit | -0.20% | 0.40% | 0.90% |
| All maturities credit | -4.70% | -2.60% | -0.50% |
Source: AXA IM as at 31 March 2013
Although Trindade says it is impossible to predict when there will be a dramatic drop in government bond prices, the writing is certainly on the wall.
"In January, government bond yields rose by 30 basis points and that is a big move in just one month. Investors felt more comfortable with the global economy and had started to move into higher risk assets; however, then came the Italian elections, which scared people off again."
"They went back into Bunds, gilts and Treasuries, so there was a mini rally in government bonds. Yields had risen from 1.8 per cent up to 2.1 to 2.2 per cent, but then retreated back to below 2 per cent."
"They have been in a trading range for quite a while, but an increase of above 2.5 per cent on government bonds would be more meaningful and investors might start to think it is the start of a new cycle."
Trindade took over the £66.3m AXA Sterling Short Duration Credit Bond fund in July 2012.
According to FE Analytics, over that time the fund has returned 4.01 per cent while the IMA Sterling Corporate Bond sector has returned 10.45 per cent.
Performance of fund vs sector since July 2012
Source: FE Analytics
Although the fund has underperformed against the sector average, its objective is to shield investors from rising government yields. The portfolio has been considerably less volatile than the average fund in the sector.
Trindade says there are a number of ways he is maintaining low volatility and protecting his portfolio from any such increased yields.
"In our fund, we don’t hold any bonds that have over five years to maturity. That is because we don’t use any derivatives to bring down overall duration in the fund," he explained.
"Corporate bond funds usually have a duration of eight years, so the manager may decide to sell futures to bring that duration down to six, for example. However, there is still that liquidity constraint within the underlying bonds they hold."
"One of the benefits of this fund is that 20 per cent of the bonds we hold mature in each year, so over three years, 60 per cent of the fund will have reached maturity. This is important for two main reasons."
"If we are in an environment where yields are rising, we can buy those bonds using the capital from the credit which has matured instead of having to sell in order to buy bonds at lower prices."
"That leads on to the second point, which is it is cost-efficient. Sterling corporate credit is an illiquid market and is expensive," he added.
The manager says his preferred areas of the sterling corporate credit sector are asset-backed credit, peripheral credit and financials – primarily subordinated bonds such as lower tier two banks.
AXA Sterling Credit Short Duration Bond fund currently yields 2.2 per cent. It has an ongoing charges figure (OCF) of 0.88 per cent and requires a minimum investment of £1,000.