Portfolio Adviser • October 2016 • Axa Investment Managers

A short duration bond fund can reduce the impact of increased transaction costs and mitigate the impact of market volatility brought on by a low liquidity environment

Liquidity describes the degree to which a bond can be bought or sold in the market at the right price, in the requested size and timeframe. Before the financial crisis, markets were sufficiently liquid, bid-offer spreads were low and matching buyers with sellers was not an issue. In July 2007, banks held around 10%* of the US corporate bond market and they were happy to warehouse risk.

Following the financial crisis, however, liquidity levels in the bond market have fallen. Successive new regulations have pushed banks to de-risk their balance sheets, and therefore warehouse much fewer corporate bonds than they used to. As such, banks hold less than 0.5%* of the US corporate bond market today.

Liquidity, or rather the lack of it, continues to be a widely discussed topic in the bond market today. The sterling corporate bond market typically suffers from challenging secondary market liquidity, compared to its dollar or euro counterparts, due to less market makers, a much smaller investor base and a lack of primary issuance. There were widespread concerns that liquidity levels would even deteriorate in the euro corporate bond market following the European Central Bank’s decision to buy corporate bonds earlier in March.

The new lower liquidity environment has had a significant impact on markets and, in turn, an increased focus on transaction costs. Markets with lower levels of liquidity tend to have higher liquidity risk premia, while investors also tend to face higher transaction costs and wider bid-ask spreads in the secondary market.

One potential solution for investors looking to lower the impact of higher transaction costs is to invest in a short duration bond fund. Short duration bond funds benefit investors by enabling them to reduce their sensitivity to rising yields, mitigate the impact of market volatility and lower transaction costs in a challenging liquidity environment.

There are two common methodologies for fund managers to build a short duration portfolio. One methodology is to invest across the maturity spectrum and use derivatives to artificially decrease the duration of the portfolio. A second is to invest directly in short-dated corporate bonds, which means the portfolio duration is a direct result of the bonds that have been bought.

The second methodology enables a fund to benefit from an attractive natural liquidity profile. In the case of the Axa Sterling Credit Short Duration Bond Fund, an average of 20% of the fund matures each year as it buys bonds with a tenor of up to five years. These regular cash flows enable this strategy to:

. Efficiently meet redemptions without necessarily being a forced seller due to having liquidity from bonds maturing.

. Naturally benefit from a rising yield environment as the cash flows from frequently maturing bonds can be reinvested in the market at higher yields.

. Implement active management at a lower cost, minimising turnover when applying active strategies is crucial to avoid performance leakage through high transaction costs.

Because 20% of the fund matures each year, the fund manager can hold bonds until maturity – unless he anticipates a severe deterioration in credit quality – and still implement active strategies. This means a much lower turnover of 10%, with the cost of it being less than five basis points. This compares to a 75% average turnover for an active sterling corporate bond fund, which has a much higher turnover cost of 75 basis points; this is about the yield on the 10-year gilt.

Current challenging liquidity conditions in the bond market have resulted in investors facing higher transaction costs. An actively managed fund which invests directly in short duration bonds, and holds them to maturity, limits the turnover. This in turn lowers transaction costs, enabling an investor to reap the fund’s full performance.

Please note: short duration strategies are subject to counter-party risk, credit risk, interest rate risk and liquidity risk.

This communication is for professional investors only and must not be relied upon by retail clients. Circulation must be restricted accordingly.

‘LIQUIDITY, OR RATHER THE LACK OF IT, CONTINUES TO BE A WIDELY DISCUSSED TOPIC IN THE BOND MARKET TODAY’