There’s an investment saying which is as old as it is popular: It’s all about time in the market, not timing the market. Time is indeed a crucial yardstick of valuation, and when it comes to bonds, so too is duration.
Bond duration is a measure of a portfolio’s sensitivity to changes in interest rates and, as one of the drivers of investment returns, it is a crucial factor for investors to consider. It can be both a positive (when interest rates fall, the capital value of fixed interest securities typically rises) and a negative (when interest rates rise, the capital value of fixed interest securities typically declines).
Duration is of particular interest for investors in the current market environment because the typical bond index’s sensitivity to interest rates is rising. The duration of many key bond benchmarks, such as the Barclays US Aggregate Index, is increasing because governments and corporates are issuing longer-dated bonds.
More important risks
While active bond managers can add significant value by managing risks such as curve, credit, currency and volatility, interest rate risk (or duration) remains one of the more important risks to manage.
Removing the shackles from a manager’s ability to manage bond duration is one way investors can potentially address this risk. Flexible duration strategies don’t remove duration risk, but they do give a manager greater ability to move in and out of positions depending on the manager’s market views. For example, a manager anticipating a rise in interest rates can shorten the duration of a portfolio by reducing exposure to long-term bonds and increasing exposure to short-term bonds. Similarly, a manager who expects interest rates to fall may potentially improve returns by lengthening duration.
A more unconstrained approach – a strategy that is not bound by the parameters of a bond index, including the index’s duration – has the potential to generate higher returns while maintaining bond-like volatility.
An unconstrained approach
How would such a strategy play out in the current environment? The Reserve Bank of Australia has kept interest rates on hold for more than a year, and policy rates in the US and Europe remain at historic lows.
With the US Federal Reserve unwinding its quantitative easing program and growth picking up, interest rates are expected to begin rising eventually. However, the massive debt overhang in the global economy should constrain central banks’ ability to hike rates aggressively. This is likely to usher in an era of lower risk-free returns than Australian investors are used to receiving from their cash investments and term deposits.
There are still areas of opportunity for investors: Central banks’ accommodative monetary policies and subdued market volatility are likely to create a favorable environment for carry generation via duration, spread and volatility strategies, and promising US growth prospects and supportive monetary policy make credit-tied sectors attractive.
Nonetheless, advisers struggling to meet investors’ return expectations might consider more flexible fixed income strategies to complement existing core bond portfolios. As bond benchmark (index) duration continues to lengthen, active management of fixed income portfolios takes on even greater importance by ensuring the risks are managed in an appropriate manner.
