TwentyFour’s sustainable approach to short term bonds

What is sustainable short term bond income?

The Vontobel Fund – TwentyFour Sustainable Short Term Bond Income fund (SSTBI) seeks to provide investors with a sustainable fixed income solution that doesn’t compromise overall returns. Based on the well-known Vontobel Fund – TwentyFour Absolute Return Credit Fund (ARC), SSTBI deploys a tailored mix of positive and negative screening that is designed to reward companies for sound ESG practices.

What is the investment strategy?

Like ARC, SSTBI is an actively managed short term bond fund that aims to deliver steady returns while keeping volatility to a minimum. With strict risk parameters and a focus on short dated investment grade bonds, the managers aim to capture strong returns but with a fraction of the drawdowns expected from higher risk strategies in tougher market conditions.

SSTBI only invests in short dated bonds (0-5 years), with a minimum two-thirds allocation to investment grade at all times. The managers prefer to keep the portfolio focused at around 100 line items to allow the opportunity for stock selection alpha; there is a strong bias towards BBB rated corporate bonds but the team can also make selective use of BB rated high yield bonds, floating rate asset-backed securities and government bonds in order to help enhance yield and adapt the portfolio to prevailing conditions.

The fund’s sustainability overlay begins with a negative screen which rules out various ‘sin’ sectors, but then importantly adds a positive screen which excludes any bond issuers we score lower than 34 out of 100. This actively rewards issuers with better ESG scores, helping to ensure clients’ capital is being invested sustainably and responsibly while still benefiting from TwentyFour’s specialist and active approach to fixed income.

Why short term bonds?

Given the twin pressures of inflation and volatility, short term bonds possess some natural advantages that can help investors protect their income at this uncertain phase of the cycle.

One of these is ‘roll-down’, which is the capital gain created by the natural fall in a bond’s yield as it approaches maturity, an effect that is enhanced when yield curves are steep at the short end – as they are today. Another is ‘pull-to-par’, which becomes particularly prominent in bonds with around 12 months to maturity and reflects the reality that as a bond approaches its maturity date, it begins to ‘pull’ to its par value as default risk becomes increasingly negligible and the cash price of the bond amortises to 100.

Importantly, short maturities give short term bond strategies the opportunity to pursue yield enhancement, which can be done via a couple of distinct strategies. First, in an environment of rising yields like we are experiencing today, a large allocation to bonds with 12 months or less to maturity means a short term bond strategy receives regular principal repayments which can be re-invested at higher yields. Those invested in longer dated bonds have far longer to wait for this re-investment opportunity and may have to resort to asset sales to speed up the process. Second, short term bond strategies can look to boost yield via high conviction allocations to riskier assets, such as corporate hybrids and subordinated bank bonds, but with ultra-short maturities, where default risk has been dramatically reduced but the yield remains relatively high when compared with traditionally less risky assets. 

How are we responding to today’s market conditions?

While rising yields have been painful for many fixed income investors – especially those holding longer dated assets – we believe yields in short term corporate bonds generally look attractive given front end rates have widened significantly to price in anticipated interest rate hikes from central banks.

In recent months the team has reduced the portfolio’s duration to under two years, increased exposure to 0-12 month bonds to more than one-third of the total allocation, and increased exposure to floating rate European ABS. This is aimed at defending the portfolio against the impact of inflation and more aggressive central bank policy by limiting duration, while allowing SSTBI to target the more attractive yields now on offer in short dated bonds. Thanks partly to the upward shift in short end rates, many high quality senior financial and corporate bonds are offering yields in excess of 3% for relatively short dated risk so this has also been an area of our focus.

The team has also made high conviction allocations to corporate hybrid bonds with short maturities. Because hybrids operate according to a call schedule rather than a set maturity, they typically offer higher spreads than vanilla corporate bonds at any given credit rating as compensation for the risk that a hybrid issue may not get called. The team likes strong, investment grade issuers with defensive characteristics where a number of the yields available are still relatively high in comparison to their long term average; today some short dated investment grade corporate hybrid bonds are trading with yields in excess of 6%.