Managing Rising Interest Rate Fears

Interest rates in many countries reached historical lows in recent years as central banks aggressively cut rates in the wake of the global financial crisis. This provided a tailwind for bond investors, but all good things, inevitably, must come to an end.

As some economies show increasing signs of recovery, the interest rate cycle is showing signs of potentially turning. Investors are left facing two key questions: When exactly will interest rates rise, and how can the impact on bond portfolios be managed? These are genuine concerns for some investors.

We believe that a big rise in interest rates in the short term is unlikely. The overhang of sovereign debt in the financial system – which helped prop up economies after the financial crisis – is too large relative to GDP to be sustained unless interest rates remain low or growth surges well above expectations.

Nevertheless, the combination of slower yet stable growth, a low-inflation environment and a highly levered borrower base – a market condition we call The New Neutral – is producing a subtle rise in interest rate risk as the duration of many bond portfolios is rising.

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Bond duration is a measure of a portfolio’s sensitivity to changes in interest rates and, as one of the drivers of investment returns, it is a crucial factor for investors to consider. It can be both a positive (when interest rates fall, the capital value of fixed interest securities typically rises) and a negative (when interest rates rise, the capital value of fixed interest securities typically declines).

The duration of the benchmark Barclays Global Aggregate Index has now stretched out to more than 6.5 years in part because companies and governments are able to issue longer-dated bonds in the current benign environment. Although this trend has been less obvious on Australian shores, the duration of the Bloomberg AusBond Index has also now been pushed out to more than 4.5 years.

How big an impact could rising rates have on bond portfolios? In theory, if a portfolio with a duration of six years faced a 1 per cent rise in interest rates, the value of the portfolio would decline by approximately 6 per cent. In reality, such a big change in mark-to-market is unlikely to materialize. A well-managed bond portfolio comprises hundreds of underlying securities, each with its own duration and attributes, such as country, sector, credit quality and maturity, and the impact of a rate rise on each bond in a portfolio would therefore be different.

It’s also important to remember that, even though bond prices may decline in a rising interest rate environment,
it is not a permanent loss of capital: Bond prices tend to drift back to par as they approach maturity, when the original capital, or principal, is repaid.

Flexible duration

Nonetheless, rising interest rates can affect the value of a bond portfolio. Fortunately, the risk can be managed. One of the most effective ways is to remove the shackles from a fund manager’s ability to handle bond duration. A bond strategy with flexible duration can mitigate interest-rate risk and complement an investor’s traditional core bond holding in a rising interest rate environment.

A skilled bond manager can use a range of flexible duration approaches which not only have the potential to generate higher returns than a core portfolio, but also have the advantage of maintaining the portfolio’s bond-like volatility. A flexible duration portfolio also retains the other traditional attributes of a bond fund – diversification, daily liquidity, income and capital protection.

For example, if interest rates are expected to rise, then a portfolio manager using a flexible duration approach can shorten the duration of the portfolio by selling long-term bonds and buying short-term bonds. It is a simple strategy but one that requires extensive breadth in the bond market and management skill.

In the global bond market – valued at approximately $100 trillion, almost double the size of the global equity market – a skilled manager can find many opportunities for managing duration and enhancing investment returns. If interest rates are rising in the US, for example, a portfolio manager can lower exposure to that country to manage the portfolio’s duration.

Similarly, varying the exposures in a portfolio to certain bond sectors, such as mortgages, corporate bonds and floating-rate securities, can also help protect a portfolio against rising interest rates.

Increasing the potential for higher returns

While managing interest rate risk directly is crucial, taking advantage of other opportunities to increase bond returns is also important in a rising interest rate environment. The current market presents a range of opportunities for bond investors.

Central banks’ accommodative monetary policies are likely to create a favourable environment for generating additional returns via spread strategies. Promising growth prospects in the US and strong corporate balance sheets in several developed markets, including Australia, also make credit-related sectors attractive.

Many investors could benefit by looking at their bond portfolios now, while interest rates remain low, and assessing how well they are positioned for rising interest rate risk. A flexible duration strategy designed to mitigate interest rate risk and improve returns can help bond investors navigate the next stage in the interest rate cycle.

Data as at 30 June 2015.

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