19 January 2022
The recent movements in global yields underscore just how challenging it is for investors to anticipate inflation, central-bank policy and the associated market moves during this post covid era of unprecedented stimulus. While global vaccination progress has continued, supply disruptions, labour-market constraints and the immense amount of new money created over the past eighteen months have combined to sustain inflationary pressures. Given the duration risk across all markets, if the current trends continue and inflation proves stickier than anticipated, some investors could be in for somewhat of a surprise.
One of our bear case scenarios from our most recent quarterly update was that inflation might continue to surprise to the upside, settling at levels higher than markets have become accustomed to. If this plays out and central banks raise interest rates sooner and faster than forward guidance, investors will need to take important steps to limit negative impacts across all asset allocations, particularly within fixed-income allocations.
Using duration to gauge interest rate risk
Rising interest rates threaten the value of all traditional fixed interest portfolios, but it’s of far greater significance to those with passive longer-dated allocations. Duration measures how sensitive a bond’s price is to interest rate changes. In general, the higher the duration (measured in years) of a bond, bond fund or index, the more its price will drop as interest rates rise (and visa versa).
As the name suggests, passive and index funds cannot alter their duration exposure to minimise interest rate risk because they they tend to replicate the index. For example, if rates rose 1%, a passive allocation with a 5-year average duration would likely lose ~5% of its value1. Said another way, if rates rose 3%, the capital value would fall by around 15% (extreme example). While coupons received during the period will offset some of these losses, a sudden increase in yields may result in an immediate capital loss for passive fixed-income investors (see figure 2). At Elston, within Fixed Income, we have for a while prioritised capital perseveration over income generation and look to avoid these instances of capital loss.
Figure 1. % Change in bond prices if rates spike 1% .
Source: Elston Asset Management
Shortening a portfolios overall duration limits exposure to interest rate turbulence. Instead of being aligned with the index, active managers with flexible mandates can shift their portfolio duration to minimise capital losses or go a step further to strategically position to benefit from the moves in either direction.
Figure 2: Australian Fixed income 1M 3M and YTD returns (as at 30/10/2021).
The below monthly returns for the Fixed Income Component of Elston’s Flagship Multi-Asset Portfolios2 demonstrate how active managers can capitalise by managing interest rate sensitivity by altering their duration exposure.
During late 2020 and early 2021, the reflation theme that gripped markets saw bond yields rise sharply. At the time, the Elston Fixed Income components interest rate duration was sitting at ~1.2 years, far below the ~5 years of the Composites benchmark3, seeing the component outperform on a relative basis. As markets focused on the ‘reflation trade’, the subsequent higher yields began to offer some value, the employed managers increased their duration. While not outperforming, this positioning saw the portfolio benefit as the ‘inflation is transitory’ narrative took hold toward the middle of the year, driving yield curves flatter as longer-dated issues fell. The more recent upward moves have seen the component benefit from its lower strategic level of interest rate duration. This is admittedly, a shorter-term period for analysis; however, the example demonstrates how active duration management can benefit investors.
Source: Elston Asset Management
Source: Elston Asset Management & IRESS
As time moves forward, we will better understand inflation and whether or not it is transitory. The potential headwind of rising rates coupled with the duration exposure that afflicts indices reinforces the need for more active exposures and selecting managers with flexible mandates. While it’s extremely difficult, if not impossible, to accurately predict the future path of interest rates, examining duration provides a reasonable estimate of how sensitive your fixed-income holdings are to a potential change in interest rates serving to minimise the risk of loss. Moreover, it’s important to emphasise that an index is not a fiduciary . It is a defined opportunity set. It doesn’t consider whether that opportunity set is aligned/appropriate with/for the investor’s objective/risk tolerance.
1 This hypothetical example is an approximation that ignores the impact of convexity
2 The Elston Fixed Income component is currently comprised of the Janus Henderson Tactical Income Fund, The Macquarie Income Opportunities Fund (MIO) and the Ardea Real Outcome Fund.
3 The Elston Fixed Income Benchmark is an index calculated as the weighted average of the indices selected as benchmarks for each asset class