There is a significant amount of fear from investors in bond funds about what will happen to returns in a time of rising interest rates. Many investors understand the inverse relationship between rates and return caused by a concept called duration; sensitivity of interest rates to movements up or down in bond yields.
However, this has often led to the incorrect assumption that duration is the only lever a bond manager has to handle rising interest-rate environments. Instead, strategies such as credit, inflation-linked securities, currency, and curve positioning can benefit from rising rates, which we’ll now explore in more detail.
Duration and Rates
The logical duration strategy for fund managers to combat rising rates is to underweight or short duration. However, this has some flow-on effects, as duration is a key characteristic in bonds having low or negative correlations to equities in periods of market stress.
Typically, lower duration reduces the strategy's potential diversification. Another consequence of holding lower levels of duration is that it, in most cases, reduces yield, which is a critical requirement from investors.
This may force managers to look for supplementary income in more risky parts of the fixed-income market. An additional point on yield is that this income serves to "buffer" any capital movements stemming from interest-rate increases.
To illustrate the point: If the index has a duration of five years and an income of 2.5%, interest rates could increase by 0.5% before investors would experience a negative total return. The formula is interest rate change X duration in years + coupon income.
As most core strategies are benchmarked to an index, they will always have a base level of embedded duration and, hence, will always be sensitive to changes in bond yields. Allowable duration bands across strategies are all different, and in our opinion the level of flexibility should be a consideration when investors decide where to allocate. That said, while duration management is critical to return outcomes, it is notoriously difficult to sustainably predict.
Curve
A lesser understood strategy available to managers is to allocate different maturities along rates curves to speculate on the changes in its shape. The two main strategies implemented are yield-curve steepeners or flatteners.
A yield-curve-steepening strategy is implemented when managers believe the long end of yield curves will sell off relative to the shorter maturities. Incidentally, this is the strategy most managers implement in a rising-rate environment as increases in short-term interest rates will usually have a knock-on effect, upward repricing if not already priced in, further along the curve.
This strategy is implemented by underweighting relative to the benchmark exposure or shorting a 10- or 30-year bond while overweighting or going long shorter-maturity bonds. A yield-curve flattener is a strategy that is more popular in environments where there is an assumption of lowering interest rates
It is a mirror image of the steepener strategy, which means a manager will buy more 10- and 30-year maturity bonds while underweighting the shorter-term maturity. The manager is taking advantage of the multiplier effect of the longer duration to get the best payoff from a low growth, low inflation, reducing-rate environment. Exhibit 1 is an example of the US Treasury yield-curve flattening between January 2017 to June 2017.
Critically, a manager can implement these strategies without materially changing the overall duration of the fund. Furthermore, managers with a global mandate can take advantage of the shape of overseas yield curves.
Inflation-Linked Bonds
Inflation-linked bonds are securities that expose investors to real changes in interest rates as principal and interest payments rise and fall with the rate of inflation. This serves as protection for investors from the primary reason why interest rates increase – inflation.
Practically, the use of inflation-linked securities is a compelling tool in rising interest rates, as the capital will adjust upwards as inflation rises. If a 20-year inflation-linked face value is £100 with a coupon of 2.5% and the inflation rate is 4%, the principal at maturity would increase to be £220; inflation rate compounded semi-annually for the maturity period.
Additionally, the 2.5% will not change; however, as the face value increases, the physical amount of those payments will increase also; coupon X increasing face value. While this seems like a perfect instrument to hold in rising-rate environments, there are some drawbacks.
These securities have significant duration embedded within them, which can be hedged if the manager wishes, they are not as liquid as nominal bonds, and they can trade at unattractive prices.
Credit Floating-rate credit is a well-known strategy for managers to implement in rising interest-rate environments. Floating-rate securities are issued at a spread above either 10-year bonds or the short-term cash index such as bank bills, LIBOR, and so on.
This spread means that if cash rates or 10-year yields increase, the absolute level of income from the credit will also appreciate by the spread amount. This lock step between rates and income is a key reason why these instruments are highly popular with bond managers in a low-yield or appreciating interest-rate world to satisfy investors’ thirst for income to meet their own liabilities.
An important and related concept is spread duration. This measures a corporate bond’s sensitivity to changes in credit spreads. A combination of yield and maturity is the key determinant in the spread-duration calculation. The higher the credit spread duration number a manager exhibits, the higher the portfolio’s sensitivity to upside and downside from movements in credit markets. While credit is a popular tool, managers must be careful, as too much allocation to credit can significantly increase the riskiness of the portfolio in a risk-off market environment.
Currency
We are increasingly seeing currency allocations form a higher component of bond funds. Currencies can be held in different magnitudes in many bond managers' mandates. Put simply, there is often a positive relationship between increasing cash rates and strengthening currency. Because of this relationship, managers have a choice in implementing a view on rising rates by either underweighting duration or overweighting currency.
Increasingly, managers are implementing views through currency rather than duration / rates because of the holding costs. Being short duration can cost money, while a well-structured currency pair can be accretive. Currency volatility is much higher than bonds', which means it can be a double-edged sword for return outcomes for managers.
It’s notable that global managers have more levers to pull than single-market funds, given the larger universe of assets and countries.
