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#Investments — 14.01.2016

IS RISK SYSTEMATICALLY REDUCED BY SELECTING SHORT DURATION BONDS?

Thierry Trigo

Don’t confuse interest rate risk and credit risk


The case of very solvent bond issuers

 

The yield-to-maturity on fixed-rate bonds of a very solvent issuer (rated AAA or AA by S&P) provides a risk premium that is practically zero. The bond’s yield will therefore be very close to that of the benchmark rates. The yield-to-maturity of such a bond will thus depend solely on the change in benchmark rates that are US Treasury yields for bonds in USD and German sovereign yields for those in EUR. In the case of a fixed-rate bond, the bond price will decrease when benchmark rates rise (inverse relationship between prices and market yields). This is the risk to which an investor is exposed.

 

To reduce this risk, the investor should reorient his portfolio towards shorter bonds. The technical Modified Duration criterion enables us to estimate as a percentage the decline in a fixed-rate bond price versus a 100 basis points (1%) rise in interest rates. And the longer the bond’s duration, the higher this sensitivity to change in yields.

 

By way of illustration, a client holds a French sovereign bond maturing in 7 years’ time. We can consider that if the 7-year interest rates were to rise by 1 point today (going, for example, from 0.28% to 1.28%) the price of this bond would decrease by around 6.30% (corresponding to the bond’s Modified Duration). Consequently, by deciding to sell his 7-year bond in order to buy a shorter one, the investor will be less exposed to interest rate rises. A French sovereign bond with a 2-year maturity has a Modified Duration of around 2.4 so much lower than that of the 7-year duration. The negative impact of a 1 basis point rise in 2-year yields would thus be around 2.40% on the bond price.

 

Therefore, it can clearly be seen that a short-duration bond protects a portfolio better against the interest rate risk. It limits the bond price downside. But what about an issuer whose solvency may deteriorate?

 

 

The case of bond issuers whose financial profile may deteriorate

 

Industrial companies or banks are issuers with financial profiles that can deteriorate, even going so far as default in extreme cases (loss of capital invested and of coupons not yet received). It is therefore normal that the return on their bonds offers a risk premium in addition to the benchmark rate (which, we remind you, is the yield for an issuer with zero default risk). The higher the likelihood of an issuer default, the higher the risk premium (and the lower the rating). This premium is known as the “Credit spread” and the risk is referred to as “Credit risk”.

 

Consequently, a prudent investor will be tempted to choose a bond with a shorter duration when the Credit risk is high. We can understand that it is easier to anticipate future cash flows and an issuer’s business activity over one year than over seven years. The yield will be less on bonds with a shorter duration but still sufficiently higher than the benchmark rate. And the Credit risk will be reduced through the better visibility on the issuer’s sector and revenues.

 

 

 

So here too, a short-duration bond appears to provide efficient protection against the other risk for an investor: Credit risk. This reasoning is true in the vast majority of cases. However, it can be misleading in one specific case: that of an issuer whose liquidity situation has significantly deteriorated. And this is the scenario to be avoided by investors. We will explain these notions in our next article.