Bond composites and duration: An inconvenient truth
Bonds can play a key role in improving the capital stability and diversification of portfolios, but the February gyrations in bond markets and volatility from the major fixed-rate bond indices against floating rate exposures have re-affirmed the risks of carrying duration in a rising yield environment.
In spite of this, there has been a steady increase in duration in the most popular liability-weighted broad bond composites over the past 10 years amid record low yields and an increased tendency for long-end issuance from governments.
Furthermore, recent events have given rise to the possibility of a perfect storm of longer durations combined with a spike in volatility amid inflation surprises and increased supply, potentially leading to drawdowns not seen in decades.
Investors and advisers should be mindful of the various shortcomings of such indices and be aware of the control over risk they give up via conventional dollar-weighted allocations.
Introduction
In contrast to equities, bond investors tend to have a much greater degree of control over risk in that the two main risk drivers – duration and credit exposure – can be carefully fine-tuned and manipulated like levers.
Although the volatility of yields can vary over time (like equities, we tend to observe periods of volatility clustering), through duration, we can control the impact basis point changes in the overall yield curve can have on our bottom line.
Duration in many ways is like leverage: it magnifies the daily mark-to-market swings from yield movements and, to compensate, we should receive a higher yield, all else being equal.
Hedging out duration leaves a residual exposure to credit spread risk, and although it shouldn’t be dismissed completely (as the GFC showed), it has historically not been the main driver of bond volatility over the past 10 years.
As an example, the three to five-year Bloomberg Australian Treasury Index (a subset of the AusBond Composite investing in Commonwealth Government Securities, carrying duration but arguably no credit risk) has experienced an annualised volatility of 2.9 per cent since 2007, significantly higher than the annualised 0.5 per cent volatility of the largely maturity-matched Solactive FRB index (which carries credit risk of mostly three to five-year bank floating rate notes, but near-zero duration).
However, duration on its own isn’t the main problem with bond indices, but rather the control over risk that investors relinquish. When allocating fixed income into broad bond composites, we give up control over the levers, with duration and credit profiles fluctuating with issuance behaviour and not investor objectives.
Liability weighting and duration creep
One of the great flaws with liability weighting in bond indices is it effectively gives issuers the power to set their own weights and the AusBond Composite has become dominated by one issuer in particular over the past 10 years: the Federal Government.
Commonwealth Government securities have gone from a weight of 20 per cent of the index in 2008 to over 50 per cent by mid-2018, while corporate bonds have gone from around 30 per cent to only 13 per cent over the same period, as seen in the chart below.
Furthermore, within the Federal Government’s issuance program, there has been a clear trend of longer maturities, with the Australian Office of Financial Management building out the ‘ultra-long’ part of the curve – introducing a 20-year bond in 2013 and a 30-year bond in 2016. This has resulted in the effective duration of the overall AusBond composite increasing from 3.2 years to 5.2 years, a 62 per cent increase in yield exposure.
This trend of longer maturities from sovereign issuers hasn’t been limited to Australia, with the past five years, in particular, seeing a rise in ultra-long issuances largely unseen in the post-WW2 period, with governments looking to lock in historically low borrowing costs amid unprecedented central bank buying as part of quantitative easing (QE) programs. Some notable examples include 100 year “century” bond sales from Austria and Ireland last year and in 2016 respectively.
As a result of the maturity extensions from sovereigns, we’ve seen the average duration of the overall Bloomberg Barclays Global Aggregate increase from a low of around 4.5 years to 7.04 years at the end of 2017.
A perfect storm?
An implication of the increased duration in broad indices is that they are more exposed than ever to an increase in the volatility of underlying global yield movements.
One commonly cited measure for expected yield volatility is the Merrill Lynch MOVE index, which measures the annualised standard deviation (in basis points) of expected movements of US Treasury yields, as implied by the options market (similar to how the VIX captures expected volatility for the US equity market).
For much of the pre-crisis period, the implied volatility on Treasury yields was around 100 basis points and the post-crisis period has seen this index trend lower alongside QE operations from global central banks, dropping to a historical low of 44 basis points in November 2017.
With the US Federal Reserve in the midst of a tightening cycle and other central banks looking to normalise monetary policy and contract their balance sheets, it is not unreasonable to expect to see heightened yield volatility over the next 12 months, with the recent episode in February amid inflation concerns potentially just a sample of things to come.
Comments from central bank officials, results of government bond auctions and the releases of economic data are now key risk events to an even greater degree than before. Ultimately, it is important for investors in Australian fixed-rate debt to be aware that global macro risks can overshadow domestic developments and issuer-specific factors.
Furthermore, investors and advisers should carefully assess whether allocating to liability-weighted bond composites is truly in the best interests of their portfolios, given the increased exposure to such risks. Duration, being a source of risk premia with a low correlation to equities, has benefits, even at relatively low yields, but it’s important not to lose control over it.
Alternatives to broad bond composites
For those investors and advisers looking to reduce duration exposure, this could be achieved by allocating to Australian floating rate bonds – such exposure is easily accessible via ASX-traded ETFs, such as the BetaShares Australian Bank Senior Floating Rate
Bond ETF, which provides exposure to a portfolio of some of the largest and most liquid senior floating rate bonds issued by Australian banks, with income paid monthly.
Alternatively, for those who would like to maintain fixed rate exposure but with a more stable duration profile, an ETF such as the BetaShares Australian Investment Grade Corporate Bond ETF provides a relatively stable duration and credit spread duration profile by investing in AUD-denominated corporate bonds with maturities limited to between five and 10 years, with income also paid monthly.
Chamath de Silva is a portfolio manager at BetaShares.
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