Rethinking liquidity with short-dated bonds

Managing liquidity to meet upcoming liabilities to members is a crucial consideration for pension fund and treasury managers. But holding cash can be a drag on overall portfolio performance, especially when returns from other asset classes are more attractive. As such, it's become imperative to explore alternative avenues for improving risk-adjusted returns.

Short-dated bonds – A compelling alternative to enhance cash returns 

Short-dated bonds typically have maturities ranging from one to five years, making them a suitable bridge between cash holdings and longer-term fixed income investments. While riskier than cash, the higher returns on offer, limited volatility and natural liquidity of short-dated bonds make them an attractive alternative. Low duration, attractive carry and diversification can help to mitigate the negative impact of rising government bond yields and widening credit spreads, reducing drawdowns during market downturns. 

There are key characteristics of short-dated bonds that make them particularly suited for liquidity management. 

• Low volatility: Short-dated bonds tend to exhibit lower price volatility compared to their longer-term counterparts, making them an attractive option for cash liquidity strategies.
• Natural liquidity pipeline: As short-dated bonds mature, the principal is returned to the investor, creating a natural liquidity pipeline. This reduces the need to trade and incur additional costs, further benefiting portfolio performance.
• Pull to Par: In environments where bonds are trading at a discount, the pull to par opportunity – where bonds are redeemed at their face value upon maturity – is attractive. This can potentially enhance returns, even when central bank rates are rising.

Active management to mitigate risk

Passive strategies can be useful in certain situations, but we believe that a short-dated bond allocation will benefit from active management. Active managers can seek out bonds with favourable risk-reward profiles, capitalizing on market inefficiencies. An active manager has the flexibility to select bonds carefully, reducing the possibility of defaults. By conducting rigorous credit analysis, they can construct a high-quality portfolio, minimizing the impact of potential credit events.

In passive strategies, bonds that experience a rating downgrade may be automatically sold, potentially crystallizing losses. This can impact potentially attractive bonds that are caught up in structural shifts – for example, when sectoral influences see all companies in an area being re-rated, without paying attention to the characteristics of individual issuers. Active managers, on the other hand, can choose to hold a bond when the rating changes, and can hold it to maturity, avoiding forced sales at inopportune times and preserving capital.

Enhancing performance and liquidity 

Bond yields remain high, and the short-dated part of the market continues to look very attractive due to inverted sovereign yield curves and flat to inverted credit curves. Short-dated bonds have proven their resilience over this hiking cycle, providing much better returns to investors when compared to longer duration strategies.

As we’ve now reached the peak of this hiking cycle, central banks may start cutting interest rates from as early as June which should lead to falling cash rates. As such, there is an opportunity cost to stay invested in cash as short-dated bonds should substantially outperform it by benefitting directly from the fall in sovereign yields on the back of lower interest rates. 

Allocating a section of your investment portfolio to short-dated bonds is a compelling strategy for enhancing performance and liquidity. Short-dated bonds offer an attractive risk-adjusted alternative for cash-heavy portfolios with various liabilities or liquidity requirements. The ability to add risk and potential returns with limited volatility, the natural liquidity pipeline, and the potential for pull to par returns make short-dated bonds a valuable addition to any investment portfolio.

Moreover, opting for active management provides further benefits, such as default risk mitigation, avoiding forced sales, and the potential for yield enhancement through careful bond selection. By considering short-dated bonds as part of a cash liquidity strategy rather than a traditional bond allocation, investors can optimize their portfolios and navigate the complexities of the current financial landscape with greater confidence and improved returns.