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.

More importantly for fixed income investors, inflation can hurt bondholders by prompting central banks to hike interest rates. In some parts of the world this is already taking place, albeit slowly.

In the US, the Federal Reserve has been steadily accelerating a process of rate hikes that begin towards the end of 2015. Meanwhile, the Bank of England has hinted it could raise rates more quickly than markets expect in the event of a smooth Brexit process.

While rate rises seem further off on the continent, the European Central Bank is similarly expected to ease off on its quantitative easing programme in due course, signalling a tightening of monetary policy.

A higher rate environment spells bad news for fixed income investors, because this will lead to existing bonds falling in value, given what they yield is inferior to that of newly issued debt.

Such a development could affect the entire bond space, with some predicting grave consequences.

Rory McPherson, head of investment strategy at wealth manager Psigma, warned bond yields were “at super low levels and represent super expensive prices”, meaning capital losses in the event of a rate hike could be substantial.

"If they [bond yields] were to normalise then conventional bond funds could be in for a very nasty shock: capital hits of the order of 20 per cent would be consistent with UK bond yields pushing up 2 per cent to a level of 3 per cent,” he explained.

"The long-run average is 5.5 per cent and, were bond yields to get back to these levels, bondholders would be wearing a 40 per cent plus capital hit.”

Hit hardest

Those with a longer duration – or interest rate sensitivity – in portfolios will be hit hardest.

“Medium and long-duration bond funds have performed so well in the last few years thanks to ever lower interest rates. This led to fears that when interest rates do start to rise again these funds could experience poor performance,” said Matthew Harris, of Dalbeath Financial Planning. 

As such, investment managers have clamoured for a solution, which has come in the form of short-duration strategies.

The bout of activity here has been remarkable of late. In the last year, several major asset managers have launched short-duration bond funds for UK investors, at a time when those who invest in fixed income funds, as well as those who run them, have been scrambling to minimise their duration risk.

Funds with such an approach represent an attractive offering at a time of rising rates. With an overall duration of typically five years or less, these funds offer reduced interest rate sensitivity but can still focus on other sources of returns, such as stockpicking.