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…”
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.
And fund providers are recognising the focus on shorter-term debt. For example, Austrian manager Erste Asset Management launched its Emerging Markets Corporate Short Term fund recently to invest in EM hard currency corporate bond with maturities generally of less than three years – an approach said to offer investors a defensive position against rising interest rates.
Nicolas Chaput, CEO of Oddo BHF Asset Management (profiled in the May 2017 InvestmentEurope issue), notes that “the Oddo Compass Euro Credit Short Duration has been our bestseller in 2016 and hit the €1bn mark. We have recorded some €200m of inflows since the start of 2017 for this fund.”
Stefan Keil, qualified portfolio manager (ebs/DBG) at NORD/LB, Germany, says a key change has been to move “major parts of our bond exposure from the euro area into the dollar area”.
As to the question of periphery versus core eurozone government bonds, he says: “The strong increase in Italian and French government bonds against German government bonds offer an interesting entry level in the expectation of a weakening uncertainty before the upcoming elections.”
Keil and his team rely on what he calls a barbell structure when it comes to handling duration risk.
“We invest in long duration with relatively high liquidity. We are not afraid of long duration and see opportunities in active selection. Avoidance of duration risks has led to a clear underperformance in recent years. This trend will continue.
“We are aligning our exposure to our medium-term expected spread performance. We believe in “meanreversion”. We control the duration in our portfolios depending on the strength of the deviation. We currently consider European corporate bonds to be unfavourable.”
Silvestro Bonora , portfolio manager at Italy’s Zenit, points out that as the ECB withdraws its support to the market, investors will be forced to reconsider allocation both in terms of instruments and geographical area.
“The spread between the core bonds and peripherals ones should be evaluated like a gauge of the solidity of the country and through this a fair appraisal about the risk in which you are involved in can be taken.
“In the current environment, the choice for a correct payoff could be affected by the artificial market that the monetary policy is creating and, in some cases, it could bring to an underestimation of the real risks that these issuances could set out in terms of duration. Therefore, the correct approach must consider every source of risk and endeavour to carry out the best evaluation possible.”
And he adds: “Today more than ever the duration is an important factor to consider in order to make a good selection. If inflation is expected to rise, the different policies that the central banks are going to impose will require much more caution on this specific risk.”
Ricardo Duarte, head of Research and Strategy at Portugal’s CA Gest, also points to the risks associated with changing ECB policy.
“Taking into account the risk of rate normalisation in the eurozone, where the ECB may give some hints on QE removal later on in the second half of the year, we would currently favour US/global bond exposure rather than European exposure. The ’spread’ between US and European yield curves is still very high by historical standards and there’s some room for disappointment in the US where ‘reflation trades’ seem to be reverting.
“Currently, we are low duration and overweight periphery vs core countries. We are still constructive on ‘spread’ compression in the periphery but much more cautious in what concerns duration. Even if inflation does not pick up materially in the region, investors will start questioning what will happen to the ECB monetary support after the end of the year.
“Duration is clearly a more important factor this year. Unfortunately, ‘spreads’ in the corporate space do not provide a ‘cushion’ either, especially if we are restricted to the investment grade segment.”
Duarte adds that this environment means he is likely to favour unconstrained managers, especially around the issue of managing duration risk.
Arezki Sehad, portfolio manageranalyst at Myria AM, outlines three key reasons for adjusting the fixed income exposure in a balanced portfolio.
“Firstly, the very low yields, negative in the shorter maturities, reduce the cushion of ‘regular’ return in portfolio. The disappearance of this ‘safe’ return make the balanced portfolio more vulnerable when the equity market is under down pressure. There is no significant positive coupon incoming in the portfolio to compensate the volatility of equity stock price.
“Secondly, whereas the correlation between bond and equity markets is null on average and becomes even sharply negative when the volatility of equity is growing, and reduces considerably the tail risk in balanced portfolio, we currently observe that, as yields near the psychological bottom of zero, the potential increase in decorrelation if equity market collapse is much lower.
“Thirdly, even if the European Central Bank offers a huge support for the market, the political risk is higher because of the growing popularity of Eurosceptic theses on the Continent.”
He concludes: “For all these reasons, we are staying non-invested in European sovereign bonds and prefer corporate credit, especially short term high yield bond because the credit spread, even if tighter, offers additional protection against rate increase risk. Otherwise, we don’t incorporate these investment as non-correlated one and we assume that it adds risk in portfolio.
“All in all, we stay shorter in duration and we prefer exclusively corporate bonds.”
That said, Sehad also notes that duration risk needs to be carefully considered as a factor as the duration of a portfolio is only an average metric.
“Even if we prefer short duration investments, we should consider not only the quantity but also the quality of duration.
“For example, when we select credit short duration funds, we are more confident of investing in funds that focus on short maturity bonds than the others which prefer long-term callable bonds. The two bonds are short duration because the sensitivity of the callable one is measured by duration to call, but the risk is not the same.
“The callable bond has a risk of extension in maturity because the call is an option in the hand of the issuer and not an obligation. The value of the call option grows in the opposite way to the level of rates.
“So,issuers could be financially attracted to not exercise the call when rates rise, which could increase the sensitivity of this bond.”
This article was first published in the May 2017 issue of InvestmentEurope.