Managing interest rate risk in a bond portfolio

Generally speaking, investors uncertain about the path of interest rates and inflation tend to stick with shorter duration bonds as a way to mitigate this risk, while those whose greatest conviction is that an economic downturn is coming will try to be longer duration, as they expect policymakers to cut interest rates in order to stimulate economic growth, and bonds that have higher yields already locked in would be expected to rise in price.

But in a world where economic growth declines, but inflation persists, investors are therefore presented with a dilemma around whether to be short or long duration.

A representative of Pimco says: “Duration is a measure of the weighted average time it takes to receive the cash flows from a bond, including both coupon payments and the return of principal, and is an estimate of how sensitive a bond’s price is to changes in interest rates.

"Bonds with longer durations are more sensitive to interest rate changes, while bonds with shorter durations are less sensitive. This market uncertainty is compounded by the technical features of the present government bond market, with central banks selling assets at the same time as governments are issuing more debt.”

Monetary policy takes time to filter through the economy, raising the risk of a recession when the full impact of the sharpest tightening cycle in decades is felt.Pimco

Data from FT Adviser’s sister publication Asset Allocator indicates that most strategic bond fund managers were wrong about duration in 2022, as most were long, and pricing in a recession, while inflation and interest rate rises persisted, and so it was short-duration bonds that performed better. 

And since the summer of 2023, many investors have been caught the wrong side of duration, with short-duration bonds doing better despite the deteriorating economic outlook. 

Matthew Rees, head of global bond strategies at L&G Investment Management, says the key to managing interest rate risk in a portfolio is less about getting the direction of the economy or interest rates right now, and more about “understanding what the market is worried about at any particular time, because market sentiment will be moving prices in the short term”

He says: “I wouldn’t want to have a lumpy portfolio right now," that is, owning a small number of investments, rather than being diversified. "I also think that while interest rate risk is something people are very focused on, there are opportunities available as well in credit markets, and that diversification is another way to think about interest rate risk.” 

Chris Chapman, managing director – fixed income team at Manulife Investment Management, expands on this point. He notes one way to manage interest rate risk is via the geographical exposure of a portfolio. 

He says not all countries or economies are at the same point of the interest rate cycle, for example some countries in emerging markets may cut rates sooner than is likely to happen in developed markets, and if rates are being cut in one jurisdiction, but raised in another, that may represent an opportunity for diversification as each of those bond markets has its own yield curve.   

Alberto Matellán, chief economist at MAPFRE, says for clients with income as a priority, the present level of yield is sufficiently high, so they do not need to worry about prices and consequently of interest rate risk.

PIMCO's representative says: "Our base case projections anticipate core inflation will trend lower but linger above central bank targets for several quarters in the US, Europe, and some other developed economies.

"This path to central bank targets may also be bumpy and could include a slight re-acceleration in core inflation over the next few months. Monetary policy takes time to filter through the economy, though, raising the risk of a recession when the full impact of the sharpest tightening cycle in decades is felt."

The representative adds: “As shorter-term yields have risen, we’ve increased our interest rate exposure, particularly in the front and intermediate portion of the curve.

"An inverted yield curve, where short-term rates are higher than long-term rates, enables us to seek attractive income without taking significant interest rate risk further out the curve.

"If yields were to rise meaningfully from here, we may increase our interest rate exposure across our portfolios further, so that we can benefit from lower prices, and capitalise on this when interest rates fall again (and bond prices increase).”

Howard Cunningham, fixed income portfolio manager at Newton Investment Management, says that while he has a view on the level of rate risk to take right now, his conviction is dented by the technical factors described above, and how those could trump the interest rate call, even if he gets the latter correct.

He says: “We are weighing up the relatively attractive yields on offer and the prospects of capital gains, should economic growth slow dramatically against the very high levels of gross and net issuance.

"With the fiscal deficit being quite elevated (not helped by higher debt service costs), central banks turned sellers of bonds, and certain overseas investors less attracted to western bond markets.

"Additionally, both the absolute number and where on the curve it is derived from are both important. You can have the same duration by being bulleted in the middle of the curve or barbelled at either end. The combination of high front end rates and steepening of the long end of the curve leads us to favour."

Those technical factors are the great unknown within fixed income markets right now, as investors have never yet experienced quantitative tightening at the same time as bond issuance is increasing. 

David Thorpe is special projects editor at FT Adviser