Fixed Income 

Using short duration bonds to manage inflationary risks

With government bond yields at historic lows in the UK and US, many managers are taking short duration bonds to manage risk and enhance performance in the belief that yields have nowhere to go but up.

Understanding duration

But how does duration affect the risk and performance of a bond portfolio? It is worth at first defining and quantifying what is meant by the term and how it is applied.

Duration is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. It is an important measure for investors to consider, as bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations.

For the two basic types of bonds the duration calculation varies: a zero-coupon bond has duration that is equal to its time to maturity; a bond that pays a coupon will always have a duration that is less than its time to maturity.

Thus on a zero-coupon bond the entire cash flow occurs at maturity, while a bond that pays coupons yearly and matures in, for example, five years will conversely repay the amount paid for the bond sooner.

Duration is also used as a measurement of a bond portfolio’s sensitivity to interest rate movements.

This stems from expectations that stronger economic activity will fan inflation, eroding returns on securities that pay fixed rates of interest. Such worries can spark selling - and, as prices fall, that pushes up yields, which move the opposite way.

Duration and performance

While all of this may appear to be little more than arcane arithmetic, duration can be a useful indicator as to how the fund will perform, as the movement of bond yields is inversely correlated to the performance of the fund.

So, in the portfolio a manager can hold different duration bonds in order to work out a weighted duration.

For example, in Chris Bowie’s Ignis Corporate Bond fund the duration is currently 7.6 per cent, slightly below the index of 7.8 per cent. This means the manager has less duration risk than the index.

In short, this means is that for every 1 per cent that yields rise, the fund will lose 7.6 per cent, while for every 1 per cent that yields fall the fund will rise 7.6 per cent.

Last year Mr Bowie says he had duration greater than the benchmark, but says he had been shortening that position this year to now be slightly underweight the benchmark, adding that his fund is “getting ready to go quite a bit shorter.”.

“Having duration risk will be one of the biggest risks over the next five years because yields are so low there is not much left to go for. I don’t think there is much left on the table.”

At the moment 10-year UK gilt yields are trading around 2 per cent and have dipped as low as 1.9 per cent.