Fixed Income June 2017  

How duration can prove risky for investors

  • To understand why duration can be risky.
  • To learn what can help mitigate duration risk.
  • To ascertain whether a global approach can help with duration risk.
How duration can prove risky for investors

In times of volatility, clients have proved reluctant to hold risk assets but loath to let go of holdings that promise a form of diversification.

This appears to have bolstered fixed income offerings, as evidenced by robust demand. In 2016 – a year marked by both political and market upheaval – bonds represented the most popular asset class for UK retail investors.

Investment Association (IA) figures show that while equity funds shed some £7.8bn overall that year, their counterparts in the fixed income space attracted net sales of £3.8bn.

This is not without reason. Bonds are often prized for their defensive qualities but have also continued to gain value, in part due to loose monetary policy.

Meanwhile recent political tremors have continued to aid performance. In May, as the outcome of the UK election appeared less certain than previously assumed, 10-year gilt yields – which move inversely to prices – reached their lowest level since October 2016, falling below the 1 per cent threshold.

The picture is not entirely rosy, however. At a time when bond valuations look alarmingly high, various forms of debt seem vulnerable to a pickup in economic activity and the subsequent return of inflation and monetary tightening.

This marks a major shift in scenario for those running portfolios. Some 18 months ago, global concerns were centred around possible sources of deflation, such as a slowdown in the Chinese economy.

But a number of events, including Chinese stimulus and a partial recovery in commodity prices, have since led to a palpable increase in inflation, as well as broader inflationary expectations.

In developed economies this has been notable: in the UK, where an enfeebled sterling has added to upward pressure on prices, inflation reached a four-year high of 2.7 per cent in April.

In a historical context this could be considered benign. In the UK, the consumer prices index (CPI) measure of inflation has averaged at 5.2 per cent – nearly double April’s rate – since 1960.

Two threats

But for bondholders this poses two threats. Resurgent inflation can eat away at the yield provided by a bond, reducing the so-called real yield.

Cash, viewed as a safe haven, fares even worse. While this asset has tended to keep up with inflation since the 1960s, the performance of cash has fallen off in the post-crash era of low interest rates and quantitative easing.

According to some estimates, cash assets have lost around 20 per cent of their purchasing power since the financial crisis.

Philippa Gee, a fund buyer, warned clients not to underestimate the effects of rising prices, on both cash and bond yields.

“We absolutely should [care about inflation] and for those older clients who have experienced high inflation periods in their life it will be a key concern,” she said.

“To simply factor in an inflation rate of 2.5 per cent is madness. You should consider a higher rate and the impact of it when helping clients make financial decisions.”