Why it’s hard to look beyond short-dated bonds for fixed income
Key takeaways
- A huge uptick in supply and an aggressive hiking regime harmed government bonds’ status as a safe-haven asset post-Covid.
- The move from a ‘scary’ to ‘sticky’ inflation regime means the outlook for longer-dated bonds has improved.
- Despite spread compression, investors in short-dated bonds are being compensated in real terms at a level not seen for more than a decade.
- With an equal share of hikes and interest rate cuts expected across developed markets this year, an active approach to fixed income is key
Investors instinctively gravitate towards traditional safe havens during periods of stress. Classic ‘risk off’ assets such as sovereign bonds, reserve currencies and gold typically offer ballast to portfolios when uncertainty rises.
Yet the post-Covid experience challenged historical norms. Yes, gold has reasserted its appeal as a store of value and been a clear winner, especially over the past year. But elevated inflation, aggressive and unconventional monetary and fiscal policy along with sharp shifts in real interest rates have eroded the protective qualities of some havens, particularly government and long-duration bonds.
Are safe-haven assets redundant?
For the most part, asset markets have been so resilient to shocks in recent years that an investor buying the MSCI World or some other global index hasn’t needed a haven…
Safe-haven bonds
Source: Bloomberg
The post-Covid regime created two significant shifts that affected the classic inverse relationship between equities and fixed income – a huge uptick in government bond supply and an aggressive hiking regime necessitated by a surge in inflation.
While we seem to be over the worst of the latter shock (albeit we remain in a stickier inflation regime), the deluge in government bond supply is likely to remain as governments around the world ramp up spending.
Attractive valuations in shorter-dated bonds
I am comfortable that now we have transitioned from the ‘scary’ to the ‘sticky’ inflation regime, longer-dated bonds can regain some of their poise in risk-off periods.
However, while fiscal policy continues to run hot, the leap of faith required to forego still attractive valuations in shorter-dated fixed income is a leap too far, in my view…
I say this even though the outlook for interest rates is more balanced this year.
Cyclically Adjusted Primary Balance for 2026 - Successive IMF forecasts
Source: The IMF
Only the most bearish commentator would discount what looks like a broad-based global reacceleration in economic output across the G10. Certainly 2026 should at least see an equal share of hikes as well as interest rate cuts across developed markets. In this regime, an active approach to fixed income management is key.
The deluge in government bond supply is likely to remain as governments around the world ramp up spending.
We can look to Japan (the central bank of which is clearly behind the curve) and markets such as Australia/New Zealand as countries most likely to hike rates, whereas the UK (out of necessity) and the US (out of political interference) should see a continuation of easing cycles into the end of this year.
Higher interest rates mean higher yields
So why do I continue to prefer short-dated fixed income? Despite spread compression, investors are being compensated in real terms at a level not seen for the past decade.
Simply put, a higher-for-longer environment means investors earn higher yields. In the front end of the curve, investors are compensated with above-cash and inflation-beating returns.
While fiscal policy continues to run hot, the leap of faith required to forego still attractive valuations in shorter-dated fixed income is a leap too far.
Just look at the real return available on short-dated UK government bonds (which I expect to benefit from more interest rate cuts this year). Having been significantly negative for an extended period, investors are now compensated in real terms.
3Y UK Real Yields
Source: Bloomberg
In the front end of the curve, investors are compensated with above-cash and inflation-beating returns.
For the Artemis Short Duration Strategic Bond Fund, our primary area of focus is short-dated UK investment grade bonds – so the yield available is even more attractive for investors.
Add in our ability to pick out high-quality short-dated high-yield securities and the proposition becomes even more compelling. So, while valuations have certainly become more compelling for longer-dated bonds, short-dated fixed income is still the sweet spot in my view.
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