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All too often, we hear that fixed income investing is ‘all about duration’. Duration – the sensitivity of an asset’s price to movements in interest rates – is certainly an important consideration for anyone investing in the bond markets. But it’s far from being the whole story.
This is a crucial concept for fixed-income investors – especially at a time when duration risks are heightened. In recent years, investors’ appetite for long-dated bonds has driven the overall duration, and subsequent supply, of the bond market to record levels. So, now that the US Federal Reserve has embarked on a rate-hiking cycle and other central banks are retreating from the extraordinary monetary stimulus of the past decade, it’s easy to focus exclusively on the risks posed by rising interest rates. But the bond market is a vast and varied place. It has a multi-factor opportunity set, not just those that hinge on the direction of central-bank policy and thus interest rates.
An active approach to bond investing has many advantages. The prolonged period of record-low interest rates, including extraordinary monetary policy, has led to a pronounced ‘quest for yield’, with investors’ heightened appetite for higher-yielding securities driving down the yield on long-dated bonds and flattening the yield curve in the process. Long-dated issuance at historically low levels has risen in response. So, in today’s market, if you are ‘hugging’ a benchmark, you’re fully exposed to the record-high levels of duration – at a time when interest rates and their associated risks are rising and the coupon does not offset the total return impact of these moves.
Duration risk can be mitigated and managed through a variety of strategies, from shorting US Treasuries to investing in short-duration high-yield bonds to mention a few obvious approaches. In a traditional sovereign-bond portfolio you typically can’t remove all duration risk altogether. But even here, you can make relative plays on the yield curve that help to offset some of that risk, isolating a particular dimension of risk such as one part of the yield curve (either 5 years versus 10 years, or 10 years versus 30 years for example) and thus dependant on how they perform relative to each other as opposed to directional interest rate risk exposure on either element. It is important to ensure that one exploits one dimension of risk at a time so as not to confuse the risk and ultimately the returns of active strategies. The dimensions of risk, in addition to duration, available to the active manager are: curve; credit (corporate bonds); currency; country (sovereigns, both developed and emerging market); inflation and volatility.
And those opportunities are wide-ranging. Most obviously, the corporate bond market provides the opportunity to take a view on the operational health of individual companies – and there’s a whole spectrum to move along here, from the stability of the highest-rated investment-grade issues to the higher yields available from sub-investment grade bonds. In addition to this simple ‘long only’ approach, it is also possible to own the credit spread in isolation, either hedging out the underlying sovereign interest rate risk or simply using derivative instruments such as credit default swaps.
Equally, an unconstrained fixed-income strategy can play inflation or growth expectations, either directly via inflation-linked securities or by utilising inflation swaps to isolate specific levels or ranges of inflation. Currency movements offer attractive opportunities and can be held in isolation to or in conjunction with the underlying interest rate risk. For example, we could argue that the current interest rate offered in local currency Brazilian bonds is attractive but that we hold a less positive view on the Brazilian real, therefore we can buy the underlying bonds and hedge out the risk of the currency. There are also situations where currency is often the more liquid expression of the underlying market as in the case of India, where investing in the local currency bonds is a complex and drawn out process.
An active manager’s consideration of the instruments used to express a given view is often as important as the view itself. There are liquidity and scalability considerations that must factor into an investment decision where perhaps a different implementation strategy such as derivatives can offer improved fundamentals to that specific investment idea.
So, rather than being ‘all about duration’, the bond market is a subtle and complex instrument that can be played in many different ways. For genuinely active investors, diversification across the available risk factors such as duration; country; curve; currency; volatility and through careful credit selection is what matters most. And with credit dispersion likely to rise as the long bull market in bonds comes to an end, those characteristics are likely to be paramount in the months and years ahead.
