Duration: the increasing risk of going long
In the first of a two-part series exploring the flight to safety versus the quest for yield in fixed income, we focus on the appetite for duration in government debt. The low-yield environment is fueling demand for long-dated bonds, but the benefits of this approach are already starting to wane.
It’s not an easy time to be in bonds. Against a challenging backdrop of sluggish economic growth and resurgent political risk, global investors have sought safe havens such as triple-A rated government debt. But safety doesn’t come cheap, especially in an era of extraordinary monetary policies by global central banks, which have contributed to rising bond prices and falling yields.
Some investors have consequently moved into riskier assets, such as emerging-market debt, in search of better returns. But others are adopting a different approach – they are going long. By loading up on government bonds with decades-long maturities – which tend to offer better yields than shorter-dated debt – these investors hope to improve returns without adding more credit risk to their portfolios.
The demand for long-dated government bonds has traditionally been strong among institutional investors such as pension funds and insurance companies, which use these securities to match their long-term liabilities. However, in recent months a wider range of market participants, including retail investors and sovereign wealth funds, have started buying more long-dated bonds as they chase yield.
Long bonds have offered impressive capital gains in 2016. But they also bring duration risk, which refers to the increased sensitivity of long-dated bonds to fluctuations in interest rates and inflation. If the economic outlook changes, the prices of these securities could fall significantly, says Michael Grady, Senior Economist and Strategist at Aviva Investors.
“Many investors that have lengthened the duration of their bond-holdings recently are likely to go to the exit door pretty quickly in an event where you do see a genuine reflationary environment. We believe inflation will rise materially over the next six months, and that could be the trigger for a fairly significant re-pricing of longer-duration bonds,” says Grady.
The large flows into long bonds reflect the dwindling pool of ‘safe’ assets, a problem that can be traced back to the global financial meltdown of 2008-09 and the ensuing sovereign debt crisis. During the turmoil, assets previously regarded as gold-plated, such as triple-A rated securitisations, were downgraded.
When the dust settled, high-quality government bonds were left as one of few asset classes regarded as truly safe, and risk-averse investors consequently increased their allocations to these securities. For example, British pension funds have increased their allocation to gilts from 28 per cent in 2005 to 48 per cent as of December 2015, according to the Pensions Regulator.
Meanwhile, new regulation designed to improve the resilience of the financial markets further boosted demand for government bonds. The Dodd-Frank Wall Street Reform and Consumer Protection Act in the US and Basel III in Europe, along with mandatory central clearing of over-the-counter derivatives, force banks to hold an greater proportion of high-quality liquid securities on their balance sheets and to post the bonds as collateral on derivatives trades.
“The financial crisis and the regulation that followed brought about a reduction in the range of assets regarded as safe at the same time as demand for them increased,” says Grady.
Appetite for duration
Since the financial crisis, central banks in Europe, Japan and the US have kept benchmark rates unprecedentedly low – even negative, in some instances – in an effort to spur corporate investment and economic growth. And this policy has indeed fostered renewed demand for riskier assets, such as US high-yield bonds or emerging-market debt. Emerging-market debt funds received record inflows of $4.9 billion in the week ending July 20, 2016.
But the demand for the perceived safety of developed-market government bonds lingers on, reflecting continuing fears as to the health of the global economy. “Investors are looking for yield in a world where none is available in safe havens,” says Grady. “But they’re not prepared, or maybe not able, to go out along the risk spectrum.”
The options available to boost returns in fixed income are narrowing. Many institutions have bought more US Treasuries, which offer better yields than government bonds from Europe or Japan. As of August 30, the 10-year benchmark Treasury yield was 1.58 per cent, compared with 0.16 per cent for 10-year French government bonds and negative yields on German and Japanese bonds. However, the relative attractiveness of Treasuries for non-US investors has recently faded somewhat as the cost of hedging the currency risk has risen.
Other investors are focusing on a different strategy: extending the maturities of their government bond holdings. For insurers and pension funds, this strategy has the twofold benefit of bringing higher yields and enabling them to match their long-term liabilities.
“Investors are cautious about moving down the credit spectrum,” says Aaron Grehan, Senior Portfolio Manager in Aviva Investors’ Emerging Market Debt team. “There has definitely been a preference for duration risk over credit risk as a way to find yield. But you are being forced into taking on ever-greater duration in an effort to achieve some return.”
Governments are issuing ever longer-dated debt to take advantage of the strong demand; both Belgium and Spain have issued 50-year bonds for the first time this year. According to research from Goldman Sachs, the average maturity of syndicated debt issues from euro zone governments was 15 years in 2015; this is expected to rise to 25 years in 2016, based on current levels of issuance.
The performance of gilts after the UK’s EU referendum on June 23 illustrates the appetite for long-dated government bonds. Britain’s long-term borrowing costs have fallen even after the rating agency Standard & Poor’s downgraded the Treasury’s triple-A credit rating to AA in the wake of the ‘Brexit’ vote. The Bank of England has contributed to that performance, by re-launching its quantitative easing programme, putting downward pressure on gilt yields.
Since the beginning of the year, the price of 30-year gilts has increased 30 per cent. With the interest included, these securities have returned more than 34 per cent in 2016 – outperforming almost every other major asset class, including emerging-market stocks and US high-yield debt.
This striking performance can be explained by the way price changes are amplified on long-dated bonds. A general rule of thumb is that a one percentage-point change in yields results in a percentage change in the bond’s price equal to the number of years left until the bond matures. Therefore, the price of a bond with a duration of 30 years will rise 30 per cent if yields fall by one percentage point. Of course, the opposite also holds true: If yields rise rather than fall, investors will be vulnerable to losses.
Aviva Investors’ House View forecasts that, with oil and commodity prices stabilising, headline consumer price inflation will start rising more quickly in many countries over the coming months, with CPI in the US likely to hit 2.75 per cent by early 2017.
A rise in inflation could send yields higher and prices lower, and create unwanted volatility in longer-dated government debt. James McAlevey, Senior Fund Manager, Fixed Income at Aviva Investors, says the higher yields on offer may not compensate investors for this risk. “Take Japan: yields on 30-year Japanese government bonds are getting down to almost zero. You’re not being compensated as well as you used to be for taking on the extra duration – especially in a world where volatility is higher,” says McAlevey.
The recent behaviour of German and Japanese government bonds – assets usually prized for their stability – demonstrates how the interplay between price and yield can wreak havoc on long-dated bonds. Over two weeks in May 2016, the yield on 30-year bunds increased 53 basis points. While that might seem a modest move, the bunds’ price consequently fell 12 per cent, an amount equivalent to 25 years’ worth of accumulated yields on the same securities. Similarly, the price of Japanese 40-year government bonds fell 10 per cent after a marginal rise in yields in July.
Room for manoeuvre
So what can investors do to navigate this tricky landscape? Hedging fixed-income portfolios using derivatives can help managers benefit from higher yields on long-dated bonds while mitigating the attendant volatility risk. These might include swaps that contain a ‘strike price’ which limits potential gains on the underlying bonds while capping potential losses. Such instruments have become relatively cheap because of the widespread market view that yields will remain stubbornly low.
Orla Garvey, Sovereign Fund Manager at Aviva Investors, says inflation-linked bonds, such as Treasury Inflation Protected Securities (TIPS), also offer benefits. “Expectations of low growth and inflation have become entrenched to such an extent that we believe the market is under-pricing the risk of higher future inflation. This makes inflation-linked bonds very attractive. Thirty-year TIPS provide exposure to duration as well as some protection against rising inflation. If we do start to see stronger growth and inflation come through, these bonds will perform better than thirty-year Treasuries.”
Garvey says that strategies that combine some exposure to duration with protection against inflation make sense in the current environment. While central bank policies are likely to keep bond yields low for the time being, governments’ fiscal policies could spur growth – and rising consumer prices – in the future. “We’re in a strange world where markets are driven by expectations of future central bank policy and further quantitative easing, rather than underlying fundamentals. But over the longer-term, as inflation slowly rises from its current low levels, these depressed yields are unlikely to persist.”
 The Purple Book, Pension Protection Fund/Pensions Regulator, 2015
 The 3-month US dollar Libor rate has increased to its highest level since 2009, making currency hedges more expensive. The rise in the Libor rate is widely attributed to impending US Securities and Exchange Commission (SEC) regulation over money-market funds, which among other things enable these funds to charge investors for withdrawing capital. Anticipating the new rules, which come into effect in October, investors have shifted capital into funds that buy only government debt, which are exempt from the regulation. Those funds seeing outflows are consequently buying fewer short-term securities from banks; this has in turn pushed up Libor. In addition, the cross-currency basis against the US dollar has also widened, further raising the cost of hedging.
 30-year gilt prices rose 29.3 per cent between December 31, 2015 and August 11, 2016. Source: Bloomberg
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