By Antoine Lesne
The persistence of historically low bond yields across the developed fixed income markets has led investors to focus on when, rather than if, the tide will change and interest rates will start to rise. Yet for fixed income investors the real question is how these changes will impact their portfolios.
Over the past 30 years, fixed income markets have enjoyed an enviable rally. Despite some of the more significant corrections of the mid-to-late 1990s, surfing the yield curve wave has mostly been very profitable for investors.
However, with government bond yields at all-time lows, many fixed income investors are reviewing the sources of return in their bond allocations.
Recent volatility in the bond markets, coupled with concerns about inflation and rising interest rates, has put duration back on investors’ radars as a key risk within fixed income portfolios.
One way of dealing with duration risk is to invest in short-maturity bonds, which may improve risk-adjusted returns and lower the overall sensitivity of a portfolio to changes in interest rates.
There is a risk/reward trade off to consider when it comes to short duration. For investors who are not using their bond allocation to match longer-term liabilities, investing in longer-duration fixed income assets can create significant additional portfolio volatility. While it’s important to recognise that over the past 20 years, annualised returns for longer- duration bonds have been relatively strong in absolute terms, on a risk-adjusted basis, duration has not necessarily rewarded investors for the additional risk involved.
Yield breakeven, which is a useful way to look at this risk/reward trade off, divides yield by duration and demonstrates the yield an investor may expect when risk is taken into consideration.
In the current market, the risk/reward trade off favours lower-duration exposures with comparatively higher yields since it is these higher yields that help to compensate for the potential impact of an increase in underlying Treasury yields. Looking ahead, the drivers of bond performance may be less skewed towards longer dated bonds, particularly as rates plateau or increase across the curve to reflect more normal yield curves.
Keeping bonds until maturity can also help lower duration, reduce turnover and maintain diversification. Traditionally, indices remove bonds when they fall below one year of remaining maturity.
There may be times however, when markets demand a liquidity premium to sell bonds at this point, which can have a costly impact on the performance of the fund and can increase turnover in the portfolio.
Even if the bonds remain liquid, it may make little sense to become a forced seller of a bond that will soon mature at par, giving up tradable bonds and the known coupons/principals that would have been paid out upon maturity.
One way for investors to access short-duration bonds is by using an ETF, which can be used throughout fixed income portfolios to precisely manage duration risk in a cost efficient way.
Physically replicated ETFs offer investors an efficient way to manage duration risk in their fixed income portfolios and provide an upside in the likely rise in interest rates, which is only a matter of time.
Antoine Lesne is a fixed income portfolio strategist at State Street Global Advisors
Comments