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investment opportunities in short-term investment grade credit

April 2020

Defensive investments, redefined

Money market funds are a good option for investors seeking to shore up their defences. Here’s why combining them with short-term investment grade bonds might be a shrewder move.

It’s a perfectly rational move.

As the economy grinds to a halt with around a third of the global population in lockdown, investors of all stripes –  whether they’re corporate treasurers, pension managers or insurers – are building up holdings of safe assets.

Their main priority – as is often the case whenever the financial skies darken – is the return of capital rather than the return on it.

The default option for the defensive-minded is money markets. And for good reason. The closest thing to cash, money market funds invest in liquid government and quasi-government instruments that hold their capital value. Such funds are also among the most tightly regulated of all investment vehicles.

For all their advantages, though, money market funds require investors to make a hefty sacrifice: yield. With official interest rates across the developing world close to – and in some cases, below – zero, the return on cash-like securities trails inflation. Custody charges are an additional cost, further eroding the value of capital invested.

In many cases, this is a price worth paying for security.

Yet for investors that still require regular income, money markets funds are no panacea. This is where a complementary allocation to short-maturity investment grade corporate bonds might help.

Although less liquid and more volatile than cash, high-grade, short-maturity corporate bonds1 compare favourably to money markets on several fronts.

To begin with, they offer a yield that provides more than sufficient compensation for the additional risks they carry.

Indeed, compared to cash, shorter maturity bonds are as cheap as they have been in many years (see table).

Big moves in valuation
Yield moves in US and European short-term credit
Short term IG debt yield

Source: Pictet Asset Management, Refinitiv

Perhaps the most glaring testament to the market’s detachment from fundamentals is an unusual shift in the shape of the yield curve. An incongruity that has emerged in the wake of the coronavirus-inspired sell-off, yields on short-term corporate bonds have climbed sharply above those offered by longer-maturity debt. 

This inversion, which has occurred in both US and European markets, has in part been caused by investors selling their most liquid bonds simply to raise cash.

But an inverted curve is increasingly at odds with fundamental trends. 

Normally, when yields on longer-dated corporate bonds are below those of shorter-dated securities, it suggests companies might struggle to service their debts – and in as little as a few months. The last time the curve inverted in the same way was in 2009, during the depths of the sub-prime mortgage crisis. 

But just as a wave of defaults didn’t materialise then, there is little to indicate investment-grade companies will find themselves in severe financial difficulty this time round, either. 

The main reason is ample monetary stimulus.

In recent weeks, both the US Federal Reserve and the European Central Bank have unveiled unprecedented measures to stabilise corporate lending and protect otherwise sound businesses from the damage caused by the coronavirus.

According to our calculations, some 50 to 60 per cent of US short-maturity corporate bonds and about 25 per cent of their European equivalents are eligible for purchase under central banks’ extended quantitative easing programmes.2

Having both the Fed and ECB as buyers of last resort offers prospective bond investors an additional benefit – lower volatility. Indeed, the volatility of shorter-dated bonds – never high in the first place – could fall below the historic norm over the next few years. That can only enhance their defensive qualities.

Another advantage that corporate debt enjoys over money markets is the variety of investments available. Companies issuing short-maturity debt operate across all major industries – including ‘defensive sectors’ such as health care, telecommunications and utilities, which tend to do well when economic conditions are weak. In both the US and Europe, health care, telecom, utility and consumer staples firms account for around a fifth of the bond market.3

For Europe-based corporate treasurers and insurance firms, short-term corporate bonds have an added attraction. The investible universe has suddenly expanded.  

For the first time in years, non-US investors can buy US fixed income assets and hedge any unwanted exposure to the US dollar at a favourable price. That’s because the cost of the currency hedge has fallen steeply. As the Fed has cut rates more aggressively than the ECB, the cost of insuring against unwanted swings in the dollar-euro exchange rate has plummeted, taking the hedged US bond yield – the yield after the hedging cost – into positive territory. (Click here for more on the mechanics of currency hedging.)

None of this is to say that short-term corporate bonds should be considered a cash substitute. Lending money to companies – even for short periods – is inherently riskier than lending to governments in the developed world.

Nevertheless, for investors that need income and whose time horizons stretch to one to three years, short-term corporate debt can be a valuable addition to a ‘defensive’ allocation.