1 Bond, 2 Strategies: Meet The Short Duration Two-Step

by: Matt Tucker, CFA

It’s not often that one asset class can be used for two very different (and somewhat opposing) investment strategies, but that’s exactly what we’ve been seeing in the short duration bond category.

The most common short duration strategy these days is reducing interest rate risk. It’s no secret (especially if you regularly read my blog) that many investors have been shifting out of longer duration bonds and bond funds and into short duration securities this past year (see below). And with good reason: When rock-bottom interest rates finally begin their inevitable ascent, bonds with longer durations are going to take a price hit.

Fund Flows

But even as some investors are using short duration bonds to “step in” to higher interest rate risk, others are using them to “step out” of cash – and back into the market.

The reason? Having a high cash balance for an extended period of time can actually carry risks of its own. With short-term interest rates near zero, investors are receiving a negative real return on cash investments after inflation is factored in. And while some investors may view their cash holdings as a necessary layer of liquidity, others have simply been stuck in cash since the beginning of the credit crisis – without a strategy for when or how to get back into the market.

That’s where short duration bonds come in. While no investment is as safe as cash, short duration securities offer relatively low interest rate risk with the opportunity for a higher yield than cash. This is likely the reason we’ve seen many of our clients use short duration ETFs as a way to toe-dip back into the market while they wait out volatility. And because these ETFs come in a variety of categories, investors can choose the amount of credit risk they take on (for example, Treasuries vs. high yield).

So while the current market environment may not make you feel like dancing, at least the short duration two-step has you covered – no matter which direction you’re headed.

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