Start Investing | Learn to Invest

10 May 2024

What is a short duration bond?

If you’re considering a bond, one of the first questions is, do you want one with a short or long duration. A short duration means the time to maturity is generally less than 5 years, which can mean that there’s less time to wait before re-investing, or taking the funds out. This can also mean a greater degree of certainty over the expected returns.

**The differences between Securitised Credit and bonds**
	Bond	High yield bond	Securitised credit
Coupon rate	Fixed rate generally	Fixed rate generally	Floating rate in general, offers a margin above a reference rate
Cash flow to pay coupons	Generated from issuer’s underlying business activity	Generated from issuer’s underlying business activity	Generated from underlying collateral (e.g., the repayments on mortgages)
Maturity	Fixed usually, with all the principal received on the maturity date	Fixed usually. with all the principal received on the maturity date	Depends on collateral characteristics e.g., principal prepayment, default rates and structural features
Tranche	All holders of the bond receive payments and suffer losses equally	All holders of the bond receive payments and suffer losses equally	Note holders receive payments and suffer losses depending on how senior their note is
Credit rating	Depends on the ability of the issuer to repay the bond	Depends on the ability of the issuer to repay the bond. Non-investment grade bonds are rated below BBB-	Depends on the tranche’s probability of suffering losses subject to the underlying collateral and structure of the securities

What returns are generated by a bond?

When you buy a bond, you know what the fixed interest rate will be paid on it.

The returns of a bond are composed of coupon income and price changes. A key measure of bond markets is the bond ‘yield’, which is the amount an investor will get from it. Yields from bonds are inversely related to bond prices. When yields rise, bond prices fall assuming all factors unchanged. Factors driving yields include changes in credit ratings and interest rates.

What does an inverse relationship mean?

An illustrative example

The UK Government issues a £1,000, 5-year treasury bond, at an interest rate of 5%.
This means that if you purchase the bond at £1,000, you’ll get a fixed interest payment of £50 every year.
If the government bond is then traded on the market, and demand rises, the price might rise to £1,500.
The value of the bond is higher than its face value of £1,00, but the interest payment of £50 remains unchanged.
This means that the return on the bond is now 3.33% (£50/£1,500), suggesting that as demand rises the yield falls.

However, what happens if the interest rate falls?

In the above example, if the interest rates were cut to 2%, these bonds would look more attractive, as they are paying above market rate. If they are more attractive to the markets, the price of the bond would rise.

So, a cut in interest rates is likely to increase the price of bonds. A rise in interest rates is likely to reduce the price of bonds.

Interest Rate Risk: As interest rates rise debt securities will fall in value. The value of debt is inversely proportional to interest rate movements.
Credit Risk: Issuers of debt securities may fail to meet their regular interest and/or capital repayment obligation. All credit instruments therefore have the potential for default. Higher yielding securities are more likely to default.
Asset Backed Securities (ABS) Risk: ABS are typically constructed from pools of assets (e.g. mortgages) that individually have an option for early settlement or extension, and have potential for default. Cash flow terms of the ABS may change and significantly impact both the value and liquidity of the contract.
Derivative Risk: The value of derivative contracts is dependent upon the performance of an underlying asset. A small movement in the value of the underlying can cause a large movement in the value of the derivative. Unlike exchange traded derivatives, over-the-counter (OTC) derivatives have credit risk associated with the counterparty or institution facilitating the trade.
High Yield Risk: Higher yielding debt securities characteristically bear greater credit risk than investment grade and/or government securities.
Liquidity Risk: Liquidity is a measure of how easily an investment can be converted to cash without a loss of capital and/or income in the process. The value of assets may be significantly impacted by liquidity risk during adverse markets conditions.
Operational Risk: The main risks are related to systems and process failures. Investment processes are overseen by independent risk functions which are subject to independent audit and supervised by regulators.

What is a yield curve?

A yield curve is a line that plots yields (that is, the annual rate of return until maturity) of bonds with equal credit ratings but different maturity dates. There are generally three types of yield curve;

1. Upward Sloping

When an economy is growing, we should see an upward-sloping yield curve. Bonds with a longer-term maturity date typically offer higher yields to compensate for the additional potential volatility, for example with regards to interest rates.

2. Downward (inverted) sloping

A downward or inverted yield curve likely indicates an economic downturn, as investors expect lower interest rates to be used to stimulate economic growth.

3. Flat

A transition between these two scenarios could result in a flat yield curve.

How are bond yields affected by interest rates?

The interest rates set by central banks are a key driver of the cost of borrowing, for governments and businesses. When inflation falls, central banks tend to decrease interest rates to stimulate economic activity and encourage increased spending. In such an environment, bond yields tend to decrease.

The situation will reverse in a higher inflation environment where central banks can raise interest rates to slow down the economy and reduce inflation.

Why short duration?

Duration, expressed in the unit of years, measures the sensitivity of bond prices to interest rate movements. The longer the duration, the more sensitive the prices to interest rate changes. Shorter-term bonds (typically up to 5 years) are generally more resilient to interest rate fluctuations than longer-term bonds.

Illustrated example

If interest rates rise by 1%, bond prices will normally drop by around 2% and 4% for a bond with a 2-year and 4-year duration respectively. Conversely, if interest rates fall by 1%, a bond with a 2-year duration could experience a gain in value of around 2%, while the price of a bond with a duration of 4 years could increase by around 4%. This is based on previous experience in the markets and analyst views of future changes.