Consider these two best-in-class bond funds for a diversified short-duration exposure

• We prefer a short-duration tilt in fixed income, given the attractive yields on shorter-tenor bonds and the prospect of higher-for-longer rates.
• The Nikko AM Shenton Short Term Bond Fund and United SGD Fund are our top picks for a short-duration exposure to fixed income.
• Both funds have a similar objective of preserving capital, and they typically focus on investment-grade bonds.
• Both funds also utilise a laddering strategy in investing, which helps their portfolios remain relatively resilient even in a rising rates environment.

Globally, the pace of rate hikes by major central banks has slowed down in 2023 compared to the previous year. Yields have consequently risen at a slower pace as well, giving bond markets a breather following one of the worst years in history in 2022.

Despite a slowdown in the pace of rate hikes thus far, we think it is still too early to add significant duration to your portfolio. In the face of sticky elevated inflation and higher-for-longer rates, we continue to advocate investors to keep duration short for their fixed income portfolio, particularly with attractive yields on the shorter end at the moment. In this article, we provide two recommendations for fixed income investors to consider, each comprising a diversified portfolio of bonds with fairly short durations.

Prospect of higher-for-longer rates favours a shorter-duration approach

On the surface, recent inflation prints in the US and Europe appear fairly encouraging as they have come down significantly from their respective peaks hit earlier in 2023. However, we caution that inflation in these markets remain well above their central bank targets of 2%, with policymakers generally forecasting a return to target only in 2025 (Chart 1).

Recently, OPEC supply cuts have also resulted in a surge in energy prices, and we think that that could be yet another catalyst for energy inflation to move higher, considering base effects with energy inflation in the US and Europe currently in negative territory (YoY). Furthermore, for the US, if the labour market remains persistent, we could see continued demand for both goods and services, which could help to drive a broader increase in US inflation.

Ultimately, we think that upside risks remain very prominent for inflation. With this in mind, markets are currently forecasting both the Fed and ECB to start cutting rates in 2H24, and we think they may be underestimating how long rates can stay elevated. With the rising prospect of a higher-for-longer rates environment, we think that adding duration exposure appears to be premature, especially without the certainty of rate cuts. At the same time, hawkish surprises from central banks remain a risk that may exert upward pressure on treasury yields, which can negatively impact longer-duration bonds more.

Chart 1: Official Fed and ECB forecasts indicate that inflation will return to target only in late-2025

Yields on shorter-end remain attractive

Following the start of the Fed rate hike cycle in 2022, nominal yields have risen sharply across the board. Over just three years, 10y UST yields have risen from 0.78% to 4.72% as of 5 Oct, while 10y SGS yields have also risen from 0.87% to 3.46%. We also observe this increase on the shorter end: 2y UST yields have risen from 0.15% to 5.02%, while 2y SGS yields have risen from 0.16% to 3.73% (same time horizon) (Chart 2). With this increase, “income” has returned to fixed income – investors can now expect a decent return on their fixed income holdings. In addition, a higher-for-longer rates backdrop also means that the attractive yield levels may stay elevated for an extended period.

We also note that sovereign yield curves for several key markets (especially the US and Singapore) remain inverted (Chart 3). In other words, investors are receiving higher yields on shorter-tenor government securities (maturing in about 1 year), compared to longer-tenor government securities (maturing in over 5 years). This means that investors can receive even higher yields on shorter-tenor securities while being exposed to lesser term maturity risks.

Chart 2: 2y yields have risen sharply over the past three years

Chart 3: Yield curve inversion means that shorter-end yields (approx. 1y) remain relatively attractive

Active management still important in fixed income allocation

We think that active management remains important for fixed income investors. While Singaporean and Asian bond spaces continue to present multiple attractive opportunities, they also contain many idiosyncratic and company-specific risks, which can be better managed by a professional active manager. This is especially pertinent for issuers within emerging markets, or within an industry facing headwinds (e.g. Chinese property). For instance, within the Chinese property space itself, investors need to actively consider the differences between privately-owned and state-owned enterprises, in the geography of underlying portfolio exposures (e.g. Tier 1 vs Tier 2 cities in China), in the type of property itself (e.g. commercial vs residential), all of which can have a significant effect on each issuer’s ability to repay its bonds.

Related article: Asian Investment Grade Bonds: Stable fundamentals with rich valuations

Within the sphere of active management, we have identified two short-duration funds which have stood out from their peers over the past few years: Nikko AM Shenton Short Term Bond Fund, and the United SGD Fund. Given their fund strategy and positioning, as well as a track record of delivering superior risk-adjusted returns, these funds are our top picks for any investor looking to add a short-duration exposure to their fixed income portfolio.

Related article: Looking for the best-in-class Fixed Income Funds? Check out our 2023/24 Recommended Funds List.

Nikko AM Shenton Short Term Bond Fund

The Nikko AM Shenton Short Term Bond Fund seeks to preserve capital and liquidity by investing in a diversified global portfolio of good quality short-term bonds and money market instruments. It aims to outperform its benchmark: the 3m SIBOR.

Its focus on good quality credits is evident from its average credit rating of A- (all fund data as of 31 Aug unless otherwise stated). The fund’s largest allocation is also into the A- credit rating space (32%), with over half allocated into A- credits and above (including cash). Looking ahead, the fund manager intends to continue focusing on quality credits by continuing to invest in mainly investment-grade credits.

Its holdings are mainly diversified across Asia, though the fund has the option to invest globally and is not constrained by geography (Chart 4).

• China accounts for its largest single-market allocation, though we think this reflects the makeup of the Asian bond market as a whole (which has a large proportion of China bonds) rather than an explicit preference for that segment.
• Sectorally, its largest allocation is to the Financials sector, particularly into various Asian Financials which is also evident from its top 5 holdings (Table 1). Within Asian banks, the fund manager has expressed a preference for those with high domestic household deposits, strong funding and liquidity profiles, and adequate capital buffers.
• Ultimately, we believe the focus on robust fundamentals and credit profiles for Asian banks in turn supports the fund’s broader focus on quality credits which greatly helps in achieving its objective of preserving capital.

We like the fund’s relatively short duration profile coupled with its laddered approach to investing.

• The fund currently has a weighted average duration of 0.99 years. In general, it focuses on short-term issues of less than 5 years. 
• The fund uses a laddered approach in terms of bond maturities, conducted through buying bonds with different maturities such that each portion of the portfolio matures at regular intervals. This laddered approach means that mark-to-market losses can be mitigated in a rising rates environment, and monies from matured bonds can then be re-invested into higher-yielding bonds.

The fund has also displayed a superior track record against its benchmark over the longer-term horizon (Table 2). This includes a decent 84 bps of outperformance (annualised) against its benchmark since the fund’s inception in Sep 2000 (as of 31 Aug), on top of its decent performance against many of its short-duration fund peers over a longer-term horizon as well. We also like its relatively attractive (indicative) net yield of 4.97%, which generally stands higher than its peers, especially considering its A- average rating.

This fund has a relatively short redemption schedule of T+1, meaning that investors can retain significant liquidity (as redemption will take 1 business day) while attaining a decent yield pickup as well. It is also classified as an Excluded Investment Product. This fund is available in its base SGD share class with a 0.40% expense ratio, though it is also available in USD-H (0.41%) and AUD-H (0.62%) too, giving investors multiple options depending on their available liquidity. As a whole, we think the Nikko AM Shenton Short Term Bond Fund remains one of the best options for investors looking at a short-duration exposure to fixed income, particularly given its superior track record compared to its peers.

Chart 4: Fund’s holdings are mainly diversified across Asia

Table 1: Top 5 holdings of fund contain mainly Asian Financials

Table 2: Nikko AM Fund has delivered superior long-term returns against benchmark and peers

United SGD Fund

The United SGD Fund aims to achieve a yield enhancement over SGD deposits with a long-term view to preserve capital by investing in money market and short-term interest-bearing debt instruments and bank deposits. It aims to outperform its benchmark: the 6m SORA (compounded) Index.

This fund focuses on global investment-grade bonds, with an average credit rating of BBB+ (all fund data as of 31 Aug unless otherwise stated). Most of its credits fall within the BBB space, with just 1.3% considered to be below investment-grade. The fund has expressed its strong belief in the importance of downside protection, particularly in periods of market instability – one of its key attributes is its history of no defaults even throughout more turbulent periods like 2008 – 2009, 2011 – 2013, and 2015 – 2016.

Similar to the previous fund, the United SGD Fund’s holdings are also primarily diversified across Asia, though it also has holdings outside of Asia – this includes the UK (4%) and the US (3%) (Chart 5).

• Its largest allocation is also into China (23%), though the fund managers have expressed caution on the market by capping its total exposure within the portfolio.
• Specifically, they remain highly cautious and selective within China property (which they have completely divested as of Mar 22) and China local government financing vehicles (LGFV), preferring quasi-sovereigns and state-owned enterprises instead.
• Given our own research’s team cautious view on China bonds, and our view that China’s economy is headed towards greater state control, we think that the United SGD Fund’s positioning demonstrates how active managers can add significant value for investors into short-duration bonds.

The fund's top 5 holdings also contain a large number of Asian Financials like the previous fund (Table 3). The fund managers have emphasised their preference for defensive sectors with resilient balance sheets, particularly in credits with leading market shares and of systemic importance. We think this preference is validated by the presence of market-leading Financials like Mizuho and SMFG in Japan, as well as Woori Bank and Shinhan Bank in Korea.

The fund remains relatively light on duration with an effective duration of just 1.17 years. Similar to the previous Nikko AM fund, It also uses a laddered approach in terms of bond maturities, once again providing stability for the fund even in a rising rates environment (Chart 6).

The fund has significantly outperformed its benchmark over the longer-term horizon, including a 158 bps of outperformance (annualised) since inception in 1998 (as of 31 Aug). Again, this is coupled with a generally comparable performance against its peers over multiple time horizons. It also currently offers a net yield of about 4% (for the Cl A (Acc) share class).

This fund does have a slightly longer redemption schedule of T+4, which investors should take into account. However, it also offers a wide array of different share classes, including the following: A (Acc) SGD, A (Acc) USD-H, A (Dis) SGD, A (Dis) USD-H, S (Dis) SGD, and S (Dis) USD-H. This contains a mix of accumulation and distribution share classes, as well as currencies like SGD and USD-H. Within the distribution share classes, investors also have the flexibility between the Class A version with a targeted monthly payout of 4% p.a., and the Class S version with a targeted monthly payout of 5% p.a., giving investors flexibility depending on their income needs. As a whole, we think the United SGD Fund is also one of our top picks for investors looking at a short-duration exposure to fixed income, and investors can benefit from its wide array of share classes available on offer depending on their investment needs.

Chart 5: United SGD Fund’s holdings are primarily diversified across Asia, with some allocations into UK and US

Table 3: Top 5 holdings of United SGD Fund also contain primarily Asian Financials

Chart 6: Illustration on ladder approach by UOBAM

Conclusion

We believe that a short-duration tilt within fixed income continues to be warranted, given the attractive yields on shorter-tenor bonds, as well as the rising prospect of higher-for-longer rates. Within the shorter-duration bond fund space, we recommend both the Nikko AM Shenton Short Term Bond Fund and United SGD Fund, both of which have displayed their ability to provide consistent risk-adjusted returns.

As a reminder, the Nikko AM Shenton Short Term Bond Fund is available in SGD, USD-H, and AUD-H currency classes. The United SGD Fund is available in SGD and USD-H currency classes, and investors can also choose from either Accumulation, Distribution at a targeted 4% p.a., and Distribution at a targeted 5% p.a.

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.