- Market is expecting interest rates to rise in 2011 as evident in late 2010 bond market correction
- One defensive strategy is to reduce bonds’ duration, hence short duration bond funds
- “Short duration” is a relatively new categorisation for fixed income funds on our platform, introduced only in 2009
- They invest in short term debt securities with a majority of these debts maturing within 3 years
- We currently distribute 6 short duration funds with risk rating ranging from 0 to 4
- The riskier short duration funds are typically exposed to foreign exchange risk
- Our analysis shows that bonds are indeed sensitive to changes in interest rates
- Performance of higher duration bonds are more sensitive to and are also negatively correlated to interest rate movement
- Shorter duration bonds appear unaffected by interest rate movements, a true defensive alternative in rising interest rates environment
Why the recent hype on short duration funds?
If you are an avid follower of financial market reports, you would probably realise that recent reports suggest shifting bond duration exposure towards the shorter end in view of the current rising interest rate expectations in 2011 (see: Why Bond Yields have been on the rise). In fact, we had our own fair share of reports explaining the impact of duration on bonds (see: Bond Duration - What, How & Why?) as well as some ideas on investing in fixed income while interest rates heads north (see: How Some Funds Benefit From Rising Interest Rates).
In short, the current market has a homogenous expectation for global interest rates to rise in 2011 on the back of solid recovery for developed nations and rising inflation concerns for developing ones. The bond market has actually seen a correction in late 2010 with most bond prices pulling back and yields on the rise. One defensive solution is to shift towards the shorter duration fixed income products.
Consequently, this article strives to iron out the concerns and queries investors may have on such products on offer and hopefully instill confidence in investors who are looking for alternatives to protect their capital against the imminent rising interest rate problem.
What is a Short Duration Fund
If you are confused between a money market fund (MMF) and a short duration fund, fret not for you are not alone. Specific to our platform, the “Short Duration” category is relatively new, being introduced only in 2009. Prior to that, most of these short duration funds were classified as MMFs. The main reason why this new category was introduced was to differentiate between a true MMF and funds that buy into debt instruments which have short maturity terms.
With guidance from the code on collective investment scheme by MAS, “At least 90% of the deposited property of a money market fund must be deposited with eligible financial institutions and/or invested in high-quality money market instruments and debt securities traded on an organised market”. These securities should not have a maturity term of more than 366 (1 year) calendar days. For the remaining 10%, the debt instruments maturity should not exceed 732 calendar days (2 years). For more information on the code, the latest amendment dated 11 November 2009 can be found here.
In short, a fund which actively invests in short term debt securities (usually with majority holdings maturing within 3 years) but whose investment objective allows flexibility which does not comply with the code on CIS for MMFs are hence classified as short duration.
What do we have on board?
If you do a quick filter using our fund selector tool, you will realise that we currently offer 6 different short duration funds of varying risk ratings. While short duration funds are generally of low risk, some of these funds are assigned a higher risk rating as opposed to the peer group for reasons such as foreign currency exposure as well as investment objectives affecting underlying holdings. Table 1 shows the risk rating as well as a short description and quick rationale for the assigned risk rating for these 6 funds.
|Table 1 - Short Duration funds and their risk
||Schroder S$ Reserve Fund Cl A
||Similar to a MMF but has minority holdings of maturity more than 2 years.
||DBS Enhanced Income SGD
||Holds short term debt securities which may be of lower credit rating than the constraints set by the code on CIS for MMF. Also invests in callable longer term debt securities whose next callable date is less than 3 years.
||Fullerton Short Term Int Rt C S$
||May hold debt securities with maturities up to 5 years but majority of the holdings mature within 3 years.
||United SGD Fund
||Similar to DBS Enhanced Income SGD fund but tends to hold callable debt securities with a much longer maturity date (with reference to top holdings stated in factsheets), hence the higher risk rating assigned.
||LionGlobal AUD Short Duration Fund
||Hold primarily AUD-denominated money market and short term debt instruments in either corporate or sovereign issues. Exposed to foreign exchange risk, primarily in AUD.
||ING RF Emerging Mkt Debt LC Cl P USD
||Holds primarily local currency issues of short term debt instruments in either corporate or sovereign issues from emerging markets economies. Exposed to foreign exchange risk, primarily in emerging market currencies.
Source: iFAST Compilations
Are they truly defensive?
Do short duration funds really walk the talk? The easier way to find out is to observe how these funds have performed historically under a rising interest rate environment. Using Singapore as our basis, the last time we saw a rising interest rate environment was between 2003 and 2006 as shown in chart 1. During this period, the shorter term interest rates (3 months, 12 months and 2 year generic SGS bond yield) were rising while the longer term interest rates (5 years, 7 years, 10 years and 15 years generic SGS bond yield) were largely unchanged.
Over this period, let’s examine the returns for Singapore focused bond funds (which tend to have a longer duration) as well as their shorter duration peers. Using Singapore focused bond funds with available data over the same period, we looked at the average return of these bond funds vis-à-vis the average interest rate changes. The funds used for this comparison are as follows:
Based on an equal weighting, we created an index using the average daily performance of these 3 funds from 31 December 2003 to 31 December 2006. We then compare the index versus the average short term rates (simple average of 3 months, 12 months and 2 years generic SGS bond yield) and the average longer term rates (simple average of 5 years, 7 years, 10 years and 15 years generic SGS bond yield). The result is plotted in chart 2.
Chart 2 – How Singapore Focused bond funds dance with interest rates
These Singapore focused bond funds usually hold debt securities with medium to long term maturity. During rising interest rates environment, the active fund managers usually try to reduce duration exposure, a move most active managers appear to be adopting recently. This is because when interest rate rises, bond yield tends to follow (as investors will demand comparable terms on their debt securities). The increase in yield will result in bond prices falling, thus impacting the bond funds performance (NAV falls as a result). The longer the duration of the bond, the larger the degree of correction (for more information, please refer to: Bond Duration - What, How & Why?).
Nevertheless, it is evident from chart 2 that these Singapore focused bond funds are sensitive to interest rate changes (observe the inverse relationship between the “Avg SG Bond Funds” line and the “Avg Longer Term Rates” line).
If short duration funds can indeed exhibit defensive capabilities during such interest rates environment, we should expect lower volatility in performance and hopefully a positive correlation between interest rates and fund performances.
Extending the same analysis to short duration funds, we created an index using the average daily performance of these SG focused short duration funds which have available data between 31 December 2003 and 31 December 2006. The funds used in this comparison are as follows:
With reference to chart 3, the average return of short duration funds appears to be pretty linear (low sensitivity to interest rate changes) and is positively-correlated to the rising short term interest rates, a result we truly desire for a defensive strategy in a rising interest rate environment. Short duration funds not only talk the talk but do walk the walk as well.
If you are worried about a rising interest rate environment which the market is currently expecting and you are willing to forgo yield in exchange for stability, short duration funds have proven to be a good defensive alternative. Holding this bond class may reduce your portfolio volatility when interest rates edge higher. Depending on your risk preference, you may choose any of the 6 available short duration funds (the focus is not on return but rather in stability).
If you wish to avoid foreign exchange risk, we recommend the follow short duration funds (refer to their risk ratings in table 1).