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Duration just part of the story

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As economic data continue its sustaining positive path, many market participants continue to question whether the 30-year bull bond market is approaching its end. The main reason of the said questioning is based on the fact, that the improved economic data will push monetary politicians towards tightening their policies.

In reality from a theoretical perspective, the major implication of tighter monetary stimulus, such as interest rate hikes, imply a fall in bond prices due to their inverse relationship. Thus, investors’ concerns in this regard are more than acceptable when considering that the U.S. Federal Reserve hiked twice over the past 15-months, and is expected to hike for a third time too, while in Europe the European Central Bank (ECB), diplomatically, commenced tightening its quantitative easing program by reducing its monthly purchases from Eur80bn to Eur60bn, despite increasing the time period of the program.

Indeed, now more than ever, rationale investors when purchasing a direct bond or maybe a mutual fund, question the bonds duration or the average duration of the mutual fund. For clarities sake, duration is a metric used to gauge how a price of a bond reacts to changes in interest rates. For instance, if a bond has a duration of four, theoretically if interest rates rise by 1 percent the bond’s value should decline by four percent.

The interesting question I pose is how are bond fund managers tackling such situation in the current low yielding environment? Longer maturity bonds will offer a premium in yield, however at the same time bond fund managers are aware that by positioning themselves in such bonds, they are also increasing the portfolio’s average duration. In this regard as fixed-income investors still demand distribution payments, bond fund managers tend to use other mechanics to reduce average duration. The first option would be that of simply increasing the fund’s exposure to bonds with shorter maturity, but with such option, in the majority of cases, this would imply lower returns as already pointed out. The other option would be the use of derivatives, such as adding negative duration by selling interest rate futures contracts or the use of interest rate swaps. In fact, nowadays most bond fund managers are managing duration risk by using mainly the latter option.

However, duration in such environment is just part of the story. In fact, despite duration from a theoretical perspective is the sensitivity of bond prices to interest rates, the levels of the said sensitivity will vary across investment grade bonds and high yield bonds. Therefore, the interesting factor is that historically there is a gap between the theoretical perspective and how in reality markets interpret interest rate hikes. In fact, as a metric it works best when comparing bonds of similar type. For instance, the price decline on an investment grade portfolio will be larger than that of a high yield portfolio. The main reason for such rationale is that the higher coupon on high yield bonds acts as a cushion in a rising interest rate environment.

Ultimately, despite the fact that interest hikes pose a threat to bond prices, it is important that investors also consider the underlying bonds within the portfolio, as markets tend to react differently for different bonds. In my view, when considering the current market environment investors who are dependent on income should hang-on to their high yield allocations, when also considering the fact that default rates in 2017 should remain low, whilst they should reduce their exposure mainly to sovereign and investment grade allocations. As already witnessed in the last quarter of 2016, markets tend to react differently- sovereign and investment grade bonds declined, whilst HY debt remained resilient. So yes, other factors other than only duration should be highly considered.

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