For most of the last decade, short-dated sterling credit was a hard sell. A portfolio of high-quality company bonds maturing within five years yielded less than 2%, and for long stretches less than 1%. Once you took off costs and inflation, investors were paying for the privilege of lending.
That has changed. Today the Short-Dated Sterling Credit Strategy has a yield to maturity of around 4.8% and a duration of 2.1 years. For the first time in many years, investors are paid a real return for lending to good companies for short periods.
This note sets out what that yield is made of, why we keep the maturities short, and what could go wrong.
What you are paid
The yield on a corporate bond has two parts. The first is the yield on a gilt of the same maturity, which reflects where the market thinks Bank Rate will be over the life of the bond. Two-year gilts currently yield around 3.8%. The second part is the credit spread: the extra yield a company pays because it is a riskier borrower than the government. Across our portfolio that spread averages around one percentage point.
Most of the yield, in other words, comes from the gilt market rather than from credit risk. That matters. It means investors are not being paid to take on a lot of default risk. They are being paid mainly because interest rates are higher than they were.
Why short, not long
Longer-dated corporate bonds yield a little more, around 5.3% for a broad sterling index with a duration of about six years. But duration is the measure of how much a bond’s price falls when yields rise, and the difference in risk is large.
A simple way to see it is to ask how far yields would need to rise over a year before the price loss wiped out the income. For our portfolio, with a yield of 4.8% and a duration of 2.1 years, yields would need to rise by about 2.3 percentage points. For the longer index, with a yield of 5.3% and a duration of six years, a rise of less than one percentage point would be enough.
Short bonds also return cash quickly. Around a fifth of the portfolio matures each year. That cash is reinvested at whatever yields are available, so if rates rise, the portfolio’s income rises with them within a year or two. If rates fall, the bonds we already own continue to pay the higher coupons until they mature.
Short-dated credit will not make anyone rich. Its job is to make sure that when you need the money, it is there.
Spreads are tight. That is a reason to be selective.
Credit spreads are narrow by historical standards. Investors are not being paid much extra for lending to companies rather than to the government, and when that happens it is usually a sign that markets are relaxed about risk. They are not always right to be.
We have responded in three ways over the past year.
First, we have reduced our holdings of bonds rated BB, the highest grade below investment grade, from 9% of the portfolio to 4%. The extra yield on offer no longer pays for the risk.
Second, we have added to borrowers whose cash flows do not depend on the economic cycle: regulated utilities, housing associations with strong rent collection, and supranational and agency issuers such as development banks. These yield less than the average corporate bond, but they give us room to be patient.
Third, we have shortened. More of the portfolio now matures within two years than at any time since 2021. If spreads widen, we will have cash coming back to buy with.
What could go wrong
The main risk in any credit portfolio is that a borrower fails to pay. We spread that risk across around 80 issuers, and no corporate issuer is more than 3% of the portfolio. We read the bond documents, model each company’s refinancing needs and avoid businesses whose debts we would not want to hold to maturity. Even so, defaults happen, and one would reduce the value of the portfolio.
The second risk is liquidity. In March 2020, and again during the gilt market stress of autumn 2022, even high-quality short bonds became hard to sell at sensible prices for a few weeks. Prices fell, including in this strategy. We keep between 5% and 10% of the portfolio in gilts and treasury bills so that we can meet redemptions in those periods without selling corporate bonds at the worst moment. In 2022 that buffer meant we sold no corporate bonds at all, and as the bonds moved closer to maturity their prices recovered. Past performance is not a guide to the future, and the buffer reduces the risk rather than removing it.
The third risk is that rates fall faster than expected. If Bank Rate were cut sharply, the yield on new bonds would fall, and over time so would the portfolio’s income. That is the trade-off of keeping maturities short: less risk to capital, less certainty about future income.
Who uses it, and how
Our clients use the strategy in different ways. Charities hold reserves in it that they may need within three to five years. Insurers use it to back claims they expect to pay in the near term. Pension schemes use it to cover benefit payments that fall due before longer-dated assets mature. Wealth managers use it as the lower-risk part of a cautious portfolio.
What they share is a need for capital to be there when they expect to need it, with a yield that keeps pace with inflation in the meantime. Short-dated credit is not the only way to meet that need, and it is not a substitute for cash that must be available tomorrow. But at today’s yields it does the job better than it has for a long time.
This article reflects the author’s views on the date of publication. It is not investment advice or a recommendation to buy or sell any security. Capital is at risk and past performance is not a guide to future returns.