With interest rates expected to increase further, investors will increasingly focus on duration risk. The two main alternatives to a rising interest rates environment within the fixed income space are inflation linked securities or short duration funds.
An inflation linked security has a variable coupon that changes based on the level of Inflation registered by the central bank.
If we take as an example a Treasury Inflation Protected Security (TIPS) issued by the US Government, coupons are adjusted yearly. This may sound appealing, but the long maturities typical of this kind of security, expose investors to the duration risk.
If we look at the existing ETF on TIPS, we can clearly recognize the corrections during periods of increasing interest rates. Furthermore, since Inflation Linked Securities are usually issued by governments, they offer low returns.
What about a traditional fund with a very short duration?
The sensitivity to interest rate increases is shown by the modified duration. If the fund shows a 1.2 modified duration it means that the fund is expected to lose 1.2% against an interest rate increase of 1%, assuming a parallel upward shift of the interest rate curve.
While it is not interesting to invest in a short duration government bond fund because of the low interest rate paid, a short duration corporate or high yield fund may prove interesting because of the higher coupons.
Whereas spreads of lower rated issues over government paper in Europe are at historically low levels, some other markets offer interesting rates of return. In addition, default rates within a context of a growing global economy are expected to be low, making the credit risk worth taking.