April 26, 2021
Peter Wilson, Global Fixed Income Strategist
Defensive fixed-income tactics: Watch your duration
Key takeawayscall out
- As interest rates have fallen over the past decade, the durations of many investor benchmarks have been quietly lengthening, including for some credit indices where sensitivity to interest rates might not be expected to be the dominant influence on returns.
- With U.S. Treasury yields expected to rise further, we believe investors should pay attention to the duration of their bond holdings. An analysis of returns in the first quarter of this year confirms that duration has been a key determinant of returns.
What it may mean for investorscall out
- As part of our more defensive stance within fixed income, we prefer the intermediate sector within high-credit-quality taxable bonds. We view U.S. high yield as worthy of inclusion in a reflationary environment, as the shorter duration of this market makes it less sensitive to rises in U.S. Treasury yields. U.S. dollar-denominated emerging market (EM) corporates may prove more defensive than sovereigns.
Duration and interest ratescall out
Duration is a popular metric used by bond investors. Like years to maturity, duration is a measure of how long an investor has to wait to receive cash flows associated with the bond. But duration is a more useful indicator than the simple life of the bond (or bond index, or portfolio), since it also allows the investor to gauge the sensitivity of the bond or the portfolio total return to a move in yields.
To clarify by way of a simple example, the duration of the current 30-year U.S. Treasury bond is around 22.5 years. The duration of the 5-year note is just 4.9 years. This means that if yields on both securities were to rise by 1%, then the holder of the 30-year bond might expect losses in the order of 22%, more than four times as much as the holder of the 5-year note.
Over the first quarter of 2021, the yield on the 10-year Treasury note rose by 83 basis points (0.83%) and the 2-year yield by just 4 basis points (0.04%). We expect further yield rises and more curve steepening in 2021 (albeit not at the same pace as the first quarter). For investors, keeping a close watch on the duration of the portfolio and its benchmarks will likely be a key element in the more defensive stance we are advocating for fixed income.
Duration creep in government bond and aggregate indicescall out
Failure to monitor duration closely can easily result in an investor’s portfolio duration — and therefore the portfolio’s sensitivity to market interest-rate rises — being longer than the investor is comfortable with. One way this can happen is that a low and falling interest rate environment — as we have seen until very recently — might oblige income-seeking investors to move further out along the yield curve (i.e. increase the duration of their holdings) in pursuit of a target yield or coupon, leaving them with a portfolio duration significantly in excess of their particular fixed-income benchmark.
But even those investors that track benchmark durations closely may have seen portfolio durations getting longer and therefore more rate-sensitive. This phenomenon, which typically occurs over months and years rather than days and weeks, is known as duration creep. This is where the duration/rate sensitivity of the benchmark itself gets longer/higher as yields decline. In part, this is just due to the arithmetic of the duration calculation itself — a 1% coupon bond will have a higher duration than a 10% coupon bond, as the 1% bond has a larger proportion of its total cash flows in the final maturity payment, compared to the coupons. But it is also because a low and falling rate period is has historically been a benign environment for issuers who are encouraged to issue ever-longer maturity debt to refinance older, higher coupons and lock in ultra-low rates for an extended period.
Chart 1 illustrates duration creep in practice over the last decade in government bond markets. It will be seen that the duration of government bond indices in the U.S. and in other developed markets overseas has increased by around two years since 2013-2014. The duration of the U.S. Treasury index has risen from around five years to near seven years, and the duration of the index of developed market sovereign bonds (ex-U.S.) has increased from seven to nine years. That may not sound like very much, but it could mean that a portfolio tracking the U.S. Treasury benchmark would have an interest-rate sensitivity almost 50% greater in 2020 than it had in 2014.
Some credit indices may be longer than you thinkcall out
Governments issuing debt in their own currency are generally considered to have no theoretical constraints on accessing currency to repay those debts, since governments have power to tax and central banks have power to create money. Therefore, the market places few restrictions (in normal circumstances) on government debt being issued at long (10- to 30-year) or even super- or ultra-long (30-to 100-year) maturities. When we think about corporates issuing debt, even in their own currency, or EM sovereigns issuing debt in foreign currency, we might think that the same freedom to issue very long-term debt would not apply and that therefore “credit” indices will tend to be of shorter duration than government bond benchmarks.
What we see in Chart 2 is that this is only partly true in practice. Lower-credit-quality corporates issuing in dollars have been paying higher interest rates and are less able to issue very long-term debt, and this indeed (as our theory would suggest) results in the high-yield index having a relatively short duration of just under 4 years. The same applies to EM corporate debt issued in dollars, where the index duration is only a little longer — near 5 years. However, this is not really the case for investment-grade corporate U.S. dollar debt, where the index duration lengthened to almost 9 years in 2020 and currently stands at around 8.5 years – longer than that of the U.S Treasury index. Also, the decade since the global financial crisis of 2008-2009 has been a friendly backdrop for EM sovereign borrowers. Falling interest rates in dollars and a tolerant attitude from yield-hungry institutions have seen sovereign issues of dollar-denominated debt of up to 100-year maturities, and duration creep taking the duration of the EM sovereign index above eight years.
In the first quarter, duration was not your friendcall out
The practical importance of this is that investors may believe they are primarily taking a view on corporate credit, for example, or on EM sovereigns, but index duration may mean that they are far more exposed to underlying rate moves — that is, the sharp curve steepening in the U.S. Treasury market — than they realize. EM sovereign returns so far this year provide a good illustration. Year-to-date total return for the U.S. dollar sovereign index (the JP Morgan EMBIG) is -3.6% (as of April 16, 2020). But an analysis of the source of this negative return shows that -4.7% is a result of rises in the underlying U.S. Treasury yield. Spread returns have in fact been positive (+1.1%) over the same period, indicating that a favorable view on EM U.S. dollar sovereign credit quality was the correct one, but this alone could not offset the negative impact of a steeper Treasury curve on an index with a duration of over eight years!
Taking a broader view, Chart 3 looks at the relationship between indexes and their durations and total returns over the first quarter of this year — one of the largest rises in 10-year yields in recent history — across a range of fixed-income sub-asset classes. Duration of these indexes has been closely correlated with the extent of losses in fixed income. The chart also shows that the relationship is closest — i.e. the dominance of U.S. Treasury yield rises on returns has been highest — in those sub-asset classes where duration is high and has been creeping higher in recent years. Investment-grade corporates and EM U.S. dollar sovereigns stand out in this regard.
Also note that where markets have underperformed what a simple duration analysis would predict — developed market sovereigns and local currency EM debt on Chart 3 — this has been due to the currency element – lowering returns to the U.S. dollar-based investor as both developed and emerging market currency fell versus the dollar in the first quarter. More interesting are those markets that have done better than mere duration would predict — municipal bonds, U.S. high-yield corporates and EM corporates. These are shorter-duration markets where other intrinsic sources of investor attractiveness and return (domestic and international credit spreads, tax concessions in the case of municipal bonds) have been able to come into play. As we summarize below, these qualities are at the core of our recommendations for a more defensive fixed-income stance in an effort to cope with the yield rises and curve steepening that we anticipate.
Thinking about duration within a defensive fixed-income strategycall out
Within high-credit-quality taxable fixed income (such as U.S. Treasuries), we continue to prefer the intermediate sector. Its moderate duration and the ability to “roll down” the yield curve may provide some cushion for returns against rising yields, especially if short rates remain anchored as we expect.
A U.S. and global recovery, as our economists anticipate, would not likely be an unfavorable one for risk assets such as corporate debt. In this context, we consider high yield as part of a more defensive fixed-income strategy, and we maintain a neutral rating. This is because we see a reflationary environment as supportive of credit, but also because of the relatively short duration of this market leaves it less sensitive to rises in U.S. Treasury yields than investment-grade credit, as we have seen.
We are also neutral on EM sovereign debt denominated in U.S. dollars. However, the long duration of this index leaves it exposed to U.S. Treasury yield rises. For investors comfortable with the credit, we believe that the shorter duration of the corporate index may make a partial EM corporate allocation a useful portfolio addition.
Risk Considerationscall out
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. U.S. government securities are backed by the full faith and credit of the federal government as to payment of principal and interest. Unlike U.S. government securities, agency securities carry the implicit guarantee of the U.S. government but are not direct obligations. Payment of principal and interest is solely the obligation of the issuer. If sold prior to maturity, both types of debt securities are subject to market risk. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. In addition to the risks associated with investing in international and emerging markets, sovereign debt involves the risk that the issuing entity may not be able or willing to repay principal and/or interest when due in accordance with the terms of the debt agreement.
Bloomberg Barclays U.S. Corp Investment Grade Index includes publicly issued U.S. corporate and Yankee debentures and secured notes that meet specified maturity, liquidity, and quality requirements.
Bloomberg Barclays U.S. Corporate High-Yield Bond Index covers the U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB= or below. Included issues must have at least one year until final maturity.
JPMorgan Emerging Markets Bond Index Global (EMBIG) is a U.S. dollar-denominated, market cap-weighted index representing a broad universe of emerging market sovereign and quasi-sovereign debt.
JPMorgan Corporate Emerging Market Bond Index (CEMBI) is a U.S. dollar-denominated, market cap-weighted index representing a broad universe of emerging market corporate debt.
J.P. Morgan Government Bond Index-Emerging Markets Global (USD Unhedged) is a comprehensive global local emerging markets index, and consists of regularly traded, liquid fixed-rate, domestic currency government bonds.
Bloomberg Barclays Municipal Index represents municipal bonds with a minimum credit rating of at least Baa, an outstanding par value of at least $3 million and a remaining maturity of at least one year. The index excludes taxable municipal bonds, bonds with floating rates, derivatives and certificates of participation.
J.P. Morgan GBI Global ex- U.S. Index (Unhedged) in USD is an unmanaged index market representative of the total return performance in U.S. dollars on an unhedged basis of major non-U.S. bond markets.
Bloomberg Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury with a remaining maturity of one year or more.
Bloomberg Barclays U.S. Treasury Bill 1-3 Month Index tracks the market for treasury bills with 1 to 2.9999 months to maturity issued by the U.S. government.
Bloomberg Barclays U.S. Aggregate 1-3 Year Bond Index is the one to three year component of the Barclays US Aggregate Index, which represents fixed-income securities that are SEC-registered, taxable, dollar-denominated, and investment-grade.
Bloomberg Barclays U.S. Aggregate 5-7 Year Bond Index is composed of the Bloomberg Barclays US Government/Credit Index and the Bloomberg Barclays US Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 5-7 years.
Bloomberg Barclays U.S. Aggregate 10+ Year Bond Index is composed of the Bloomberg Barclays US Government/Credit Index and the Bloomberg Barclays US Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 10 years or more.
An index is unmanaged and not available for direct investment.
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