Duration duties

As concerns start to build around investment risk linked to rising interest rates fund selectors may have to pay greater attention to the sensitivity of asset prices to interest rate changes. InvestmentEurope reports.

Duration. A relatively short word that means an awful lot to fixed income investors. And given the net inflows to fixed income funds in recent years, it is one that has taken on added importance with the recent action by the US Federal Reserve, which turned market expectations of interest rate rises into actual interest rate rises.

As Eric Vanraes (pictured), head of Fixed Income Investments in the Eric Sturdza Private Banking Group, notes: “Duration is always factor number one because we only invest in very high quality bonds. As a result, the performance of our portfolios, including both corporates and governments, is essentially driven by the behaviour of interest rates and the duration of the portfolio.

“The behaviour of spreads is less significant. Obviously, our answer would be totally different should we invest in high yield or low-quality emerging markets. But we don’t…”

EUROPEAN OUTLOOK
In terms of the outlook for European bonds, Vanraes expresses therefore a note of caution.

“Due to very low government yields – five-year German around -0.5% – European high-quality corporates are not attractive as their low spread is not sufficient to reach a yield above zero. Consequently, even if we must be very cautious, the search for positive yields leads us to look at 6-7-year single-A or 4-5-year triple-B corporates. This is the main challenge for European bond fund managers because we will have to cope with a less dovish ECB after the summer holiday.

“It is very clear in our view that short-term European bonds are in a bubble and this bubble will bust once [European Central Bank president] Draghi announces a tapering in early 2018. This is the reason why we started to take profit on many CSPP corporates (Corporate Sector Purchase Program, i.e. bonds bought by the ECB for its QE program).

“We try to find more value in bonds that are not included in the ECB’s purchase program such as US, Swiss, Scandinavian or British corporates.”

Gilles Pradère, senior fixed income manager, managing director at Ram Active Investments, Switzerland, says that yields on European government and corporate bonds are “too low to compensate the duration risk”.

“Traditionally, one way to circumvent these low yields was to invest into corporate bonds. But with a large part of the investment grade bond universe yielding below 1%, the temptation is high to move down the credit ladder and invest in high yield bonds. This type of behaviour undermines the diversifying objective of a fixed income allocation due to the high correlation of the asset class to equities.”

Pradère also notes that the sovereign debt market in Europe is really split into three categories, each with their own duration risk: the very safe bonds (eg, Germany, Netherlands), higher yielding ones (Portugal, Greece), and those in-between (France, Belgium), where “their government bonds offer relatively low yields and low spreads to Germany, meaning that investors are not paid for the duration and credit risk. At these levels, we avoid buying them.”

10 GOES INTO TWO
Meanwhile, Markus Allenspach, head of Fixed Income Research, Julius Baer, cites the expression that “two years is the new 10 years” as regards European government bonds.

This is based on the understanding that although spreads on 10-year bonds were the measure of distress in the eurozone sovereign debt crisis period, the ECB itself has made comments to the effect that the new measure of distress is between two-year German and French bonds –particularly in the runup to the French presidential elections.

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