What does it mean?
Duration can be defined as the weighted average time until all the cashflows from a bond or portfolio of bonds are received. So whilst the maturity of a bond simply looks at the time until the last cashflow is received and principle is repaid; a bond’s (or portfolio of bonds) duration takes into account the size and timing of the interest coupons along the way as well as the time until the final principal is repaid.
For example, a 5-year bond with a 2% per annum fixed coupon will have a duration of 4.65 years when it is issued. This is because interest payments to the bond holder occur every year to maturity. In contrast, a 5-year zero coupon bond will have a duration of 5 years as principle and interest are all paid at maturity.
Why is it important?
- It acts as a guide for how sensitive a bond or bond portfolio is to changes in interest rates.
- The longer the duration, the more the value of the bond will vary with interest rates. For example, if you invest in a fixed interest rate and the yield falls, the price of that bond rises, and that bond becomes more valuable.
- Similarly, when interest rates are low and rising, the price of fixed rate bonds fall; after all, why would investors lock in a rate when they could be rewarded with higher interest rates in the future?
What role does it play?
In addition to duration being a useful tool to analyse bonds, it can also play an important role in portfolio construction and diversification. Historically, duration can act as a portfolio hedge for investors and has often performed well in periods of market stress and volatility. For example, in some environments with deteriorating economic conditions we may see central banks like the RBA cut the official interest rate and bond yields go lower and bond prices go up. Additionally, in periods of uncertainty, investors can seek the security of safer assets such as bonds and the greater the demand, the lower the yields and inversely, the higher the price.
How does Perpetual use duration to add value and mitigate risk?
When aiming to benefit from a fall in interest rate yields, our investment experts will buy bonds with a long duration or bonds with longer maturities relative to bonds with short maturities. Alternatively, to reduce the risk from rising bond yields, they will likely hold more lower duration (sometimes referred to as “short duration” securities in the markets) or shorter maturity bonds than longer maturity ones.
Perpetual believes that active duration management can be an important contributor to both adding value and managing fundamental (price) risk. This is done by using a propriety bond scoring process that determines duration positioning of the whole bond portfolio.
Taking an investment view of how much duration to hold in a portfolio is essentially taking a view on the direction of interest rates. For example, if the investment credit team believes the economy is slowing and inflation will drift lower they would be inclined to add longer maturity bonds to a bond portfolio in order to take advantage of a rise in bond prices on the back of lower yields. This strategy would increase the value of the total bond portfolio at a greater rate than not actively managing the bond portfolio.
The Bloomberg Ausbond Composite Bond Index
The Bloomberg Ausbond Composite Bond Index is the most widely used Australian Fixed Interest Index and measures the performance of a portfolio of domestic fixed rate bonds. The chart below shows the change in the modified duration of this index and the yield of the long dated 10-year Commonwealth Government Bond over time.
Note: Past performance is not indicative of future performance.
We can see here that the yield on the long maturity bond has fallen over time, yet at the same time, the duration of the index has increased. This is due to borrowers taking advantage of lower yields to reissue bonds with a longer maturity and results in the underlying portfolio of bonds (and the benchmark’s) duration increasing over time.
Perpetual believes that an investor’s duration exposure should not just be dictated by the arbitrary duration of a particular benchmark but instead be based on the role and rationale of these assets within a portfolio and importantly, with a sense of the current environment and outlook.
Given a world of low yields coupled with the inability of them to fall much further and the increasing duration inherent in benchmarks how you are positioned is crucial. Based on our experience and analysis, we believe a strategic duration of around 2 years may provide investors with the right sort of balance between risk and return over most cycles.
Our Investment experts take careful consideration of these changes when deciding what bonds to invest into, which may add value and mitigate risk when constructing an active portfolio.
A well-structured defensive portfolio should include a mix of both, credit and duration. There will be times in every investment cycle where more or less of each is relevant and the real question of how much, what type, where to position and so on, is fluid and at times unclear. Therefore, in today’s uncertain climate an active and aware approach makes sense more than ever.
Whilst many Fixed Income funds actively manage sector exposures and credit risk, few actively manage the key risk of duration and most have historically tended to trade closely within ranges related to the benchmarks they are measured against.
For investors seeking a fixed income solution that is designed more around outcomes rather than simply benchmarks and for those who are looking for strategies that demonstrate a proven track record in managing both, credit and duration risk, Perpetual’s Dynamic Fixed Income Fund is worthy of consideration. The intention of the Fund is not necessarily to trade on short term, low conviction signals but rather operate around the strategic benchmark and seek to add value through meaningful positions as and when there are larger market opportunities.
The Fund is designed to target absolute returns and aims to provide positive performance irrespective of market conditions. In a world that is beginning to see increased volatility coupled with low interest rates and ever-changing credit markets, we feel these tools are likely to serve investors well going forward.