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Are you in fixed interest for the duration?

The most commonly followed global bond benchmark, the Barclays Global Aggregate Index, is poised to reach seven years – not in age (it has been around a lot longer than that) but in duration, being in simple terms the index’s average weighted term to maturity. Why should we care about such a milestone? The answer lies in how the index’s duration has tracked over time and how that affects investment returns, particularly in the current context of historically low (in some cases negative) interest rates.

Know your duration

Duration is important to investors as it indicates the sensitivity of bond exposure to changes in interest rates. All else being equal, bonds with higher durations have greater price volatility than bonds with lower durations. The longer the duration, the greater the price will fall for a given rise in interest rates, and vice versa.

The chart below shows the duration history of the Barclays Global Aggregate Index.

The duration of the Barclays index has progressively lengthened, like many conventional fixed interest benchmarks, particularly over the past decade. Currently sitting at 6.9 years, this compares to 5.5 years in 2010 and an average of 4.9 years prior to the Global Financial Crisis (1990-2008). One of the drivers is the increase in longer-dated issuance by both governments and companies – who themselves have diminished in credit quality on average – to lock-in the alluring borrowing rates on offer.

The consequence for investors is that, by being in a fund which closely or broadly tracks the Index, the interest rate risk exposure has increased markedly over time. And it has happened without an investor necessarily making any active decision.

A related issue is that the yield on the Barclays Index is now just under 1.2% compared to, say, 4.3% a decade ago. Investors are receiving lower compensation per unit of interest rate risk for their investment. At the same time, the positive return ‘carry’ from hedging to local currency has fallen in recent times, alongside the Reserve Bank’s opposite monetary policy path to that of the US Federal Reserve. Hence the buffer to help insulate a fund’s overall return from any downward movement in the capital price of bonds has diminished.

So is this a comfortable state of affairs for investors? That depends on your outlook for global interest rates. If you believe yields will rise in the short-medium term (particularly at a relatively brisk pace), then that could have an adverse effect on portfolio returns. Even if you hold no view you should be aware that, by default, indexes have been changing the risk characteristics of your portfolio.

We need not jump to the conclusion that additional duration is a bad thing. Global economic weakness and low inflation over recent years have pulled yields downward, thereby generating solid returns for bond holders, and high quality credit exposure is typically a useful safe haven for investors during times of market stress. However, when it comes to duration, the relevant question is ‘how much is too much?’. There is no sign of an end to higher duration trend in conventional benchmarks. One might wonder where it will end, and moreover, what the rationale may be for an investor to passively follow.

Forewarned is forearmed

Most portfolios would do well to retain material exposure to the diversification and liquidity benefits of fixed interest. At the same time, however, some regard for ‘duration creep’ in bond indexes is warranted. This may be addressed via asset allocation decisions, or in some cases we have worked with clients to consider alternative benchmarks or partially using more absolute return-oriented solutions.

The lower-for-longer interest rate theme continues to dominate markets, but this theme is notably embedded in current equities pricing and other risk assets as well as fixed interest. Strong exposure to duration has been a tailwind to portfolio returns for an extended period, but under some economic scenarios it could be a less-than-welcome attribute.

 

David Scobie is a Principal in Mercer’s Investments business, based in Auckland. He advises institutional clients on their investment policies and structures. He is also involved in evaluating fund managers, linking in with Mercer's research capability in Australia and globally.

This article does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.

 

4 Comments
Warren Bird
August 26, 2016

Agree, David. Bond indices certainly do change in ways that equity indices don't tend to. I had discussions back in my Colonial First State days with some institutional clients about not using the off-the-shelf indices, but tailoring the duration and curve structure to align with their liabilities. Otherwise there was Value at Risk' for their business even if the fund was positioned 'at index'. (David Bell will remember this well, as he was on my team at the time and did a lot of excellent work on this.) One large mandate we had for many years took this approach, so they weren't affected by changes in the duration of the 0-5 year index.
We tended to only get traction with this sort of discussion with insurance companies who had decent actuarial estimates of their liability profile. However, I think that all investors should pay more attention to this, so again I'm glad you've raised the subject.

David Scobie
August 26, 2016

Thanks Warren, you have elaborated on another piece of the equation. Part of the reason for the index duration extension certainly relates to the downward movement of interest rates over time. And in addition to issuance patterns, on the demand side of the equation investors are being tempted to attain exposure further out the curve in order to seek some form of yield pick-up. So a few variables are in play, not to mention the changing credit quality aspect – another article in the offing! The overarching takeaway is I suggest that indices are dynamic beasts, with evolving embedded risks, some of which are not as readily observable as a headline yield but which will nonetheless impact on how the investment exposure performs over time (under differing macroeconomic and volatility scenarios).

Warren Bird
August 25, 2016

Thanks David. This article raises a meaningful issue and starts a helpful discussion about it.

I come at assessing bond portfolio risk a little differently. This starts with an observation that duration isn't the weighted average term to maturity, which is how you put it. Rather, it's the weighted average time to receive all cash flows - coupons and maturities. This might seem like just a quibble, but the distinction is important because it's the main explanation for why the index has lengthened. As yields have fallen, the new bonds issued into the market have had lower and lower coupon rates. This means that the cash flows from fixed income are becoming more dominated by the capital return at maturity.

To illustrate, look at two US Treasuries that have the same maturity date - 15 August 2026. Both are ten year bonds today and both currently yield close to 1.5%. However, one was issued 20 years ago as the then current 30 year bond and has a coupon rate of 6.75% because of the prevailing market level at the time. The other was issued this month with a coupon rate of 1.5% reflecting today's market.

The first one, the 6.75% coupon security, has a duration of 7.8 years. The recent issue, the 1.5% coupon, has a duration of 9.2 years.

So it's not that governments are issuing longer dated bonds, it's that the bonds they issue have a longer duration, even though their final maturity term is the same. And as time has gone on, and older bonds have matured, the market - the Barclays index - quite naturally has more of these more recent bonds.

Does that mean the market is now more risky? We need more information to answer that question. The prospective volatility of bond market returns - risk, if you like - isn't just measured by the duration of the market. Really, it's duration times the probability of a yield change. I'd venture to suggest that back in the 1990's when the index in your chart was at 4.5-5.0 years duration, it was more risky than now because the odds of a 1 or 2% shift in yields over a 12 month period were much greater than it is now.

It's true, as you say, that if yields rise by 1% then the capital value impact will be greater now than when duration was lower. That's a mathematical fact. And it's true that the second element of risk, the probability of a yield change, is subjective and in reality anybody's guess. But in the interests of helping investors who think about such things to make a fully informed decision, I think that both components need to be explored.

As you say in your conclusion, under some economic scenarios the longer duration of bond funds could become problematic for investors. I suspect, however, that under those scenarios, a 5 year duration market would have been just as problematic as a 7 year duration market, both producing a year or so of negative returns.

Ashley, how much would you pay for a perpetual bond paying zero interest? Sorry, that's a trick question - the answer is zero. No doubt someone out there will get sucked in should the Japanese government ever try it, but they wouldn't be fixed income investors!

Ashley
August 25, 2016

Good account of the rising duration of global bonds and the implications

· Could be a fair way off ending – ie rising duration will probably continue for some time yet – eg Japan + Europe will probably start needing to issue perpetual bonds (like the old british consols) – one step before straight-out helicopter money which is a permanent non-debt issue of money

· People often forget that in inflationary environments you want to be a borrower (eg our parents/us in the 1960s to the 1980s), but in deflationary environments (ie now and the foreseeable future) you want to be a lender. Hence I see good returns from bonds for some time – especially long duration bonds

· So the old Lehman Agg is doing us a favour by passively increasing returns for us in a deflationary world !

 

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