Ongoing uncertainty over interest rates has bond fund managers divided on how to best address duration in their funds.
The Federal Reserve and the Bank of England continue to muddy forecasts for interest rate rises this year, while central banks in the eurozone, Japan, Switzerland, Sweden, and Denmark have moved their base rates into negative territory.
Duration, which effectively measures the change in the price of a bond relative to the change in interest rates, must be addressed by bond managers when calculating the best format to deliver risk-adjusted returns for clients.
For every percentage point rise in interest rates, and therefore bond yields, returns would reduce by 1 percentage point for each year remaining to maturity on a bond.
Russ Mould, investment director at AJ Bell, says: “Given that most investors flock to bond funds as a potential source of capital protection as well as income, the desire by many managers to prefer short-duration paper is entirely understandable, as only a small increase in interest rates – and therefore bond yields – would wipe out the benefits of many years’ coupons.”
However, on some estimates it appears unlikely interest rates will rise in the near future, and many managers are moving towards longer duration portfolios despite both the risks involved and the weaker returns offered by a flattening yield curve.
Mr Mould adds: “Central banks may jawbone about tighter policy but actions speak louder than words and, if anything, they are going the other way – something which should help long-duration paper until the fateful day when markets decide enough is enough and that it is time to take control back from the would-be central planners.”
This forces bond fund managers to decide whether interest rates will rise in the near future, therefore making short-duration strategies a better position, or stay long duration to eke out extra yield as rates stay lower for longer.
Axa Investment Managers’ Nick Hayes recently increased duration by more than two years in the $509m (£353m) Axa WF Global Strategic Bond portfolio in the belief that demand for government bonds is set to continue due to a combination of low interest rates and stimulative monetary policies. Extra demand, even in the advent of rising rates, would keep yields surpressed, thereby protecting bonds’ value.
“There’s a very good reason why government bonds are so expensive and with such low yields – and that’s because of the central banks,” Mr Hayes says.
“If we don’t think that era has ended and we don’t think we will see interest rates rise aggressively any time soon, then it’s entirely possible that government bonds could stay at this [value] for quite a while.”
Mr Hayes does concede that rising interest rates could impact long-duration portfolios, and is acutely aware of the risks.
However, he adds: “We’ve had another year in 2016 like we’ve had in the last six or seven years, where people’s expectations for future interest rates have been disappointed. I would argue that the new normal is low interest rates of 0 to 3 per cent, and the new normal for government bonds might be 2 to 3 per cent. I don’t think we’re going to get to 5 or 6 per cent any time soon.”
Mr Hayes’ position is in contrast to another bond stalwart, M&G’s Richard Woolnough. In March, Mr Woolnough cut duration in his £15bn Optimal Income fund to a record low of just two years following market fears of limited future growth prospects in the US.
Mr Woolnough notes short-dated US debt has sold off more sharply this year than long-dated debt, sometimes indicative markets are pricing in a slowdown in growth, or even recession.
However, the manager believes the fundamentals do not back this, meaning stronger growth and a potential upswing in rates in future. He increased short positions in 10-year US government debt, thereby cutting duration.
Multi-manager Architas has also cut duration in its bond funds in an attempt to position the range more defensively. It has held on to gilts, which chief investment officer Caspar Rock says provide strong returns.
As expectations for rates move one way and the other from week to week, managers are faced with the same problem that has dogged them for more than half a decade: deciding whether it is worth taking on duration in order to get a higher return.
Many continue to anxiously but impatiently await a tipping point but, in the meantime, the lesson of the post-crisis years is that long duration could be less of a risk than short duration.
