The overlooked risk of bond markets

Financial markets have experienced an unusual sell-off this year as the prices of both bonds and stocks have fallen in response to sharply rising interest rates in an increasingly inflationary environment.

Major central banks, led by the US Federal Reserve, have been forced to tighten monetary policy much faster than either they or investors had expected in January to battle higher prices for just about everything that consumers purchase.

Central banks, which typically aim to cool an economy and bring down inflation by making credit more expensive, had no choice but to swing into action.

The Federal Reserve raised interest rates in March for the first time since 2018 and subsequent increases have comprised the sharpest round of US rate hikes and monetary tightening in decades. The European Central Bank followed the Fed in July, with its first interest rate increase since 2011. The resultant jump in bond yields has hurt both fixed income and equity markets amid higher borrowing costs and tighter liquidity.

To many, bond maths is a bit counter-intuitive. When yields rise, the price of bonds falls. A bond's yield rises when the price of that bond falls in anticipation of future issued bonds being more attractive. As cash rates rise, older bonds earn less than newer ones, thus they become less attractive and their market price falls.

We can think about this practically in terms of what many of us are experiencing right now - home values. As the Reserve Bank lowered interest rates, it cost less to borrow. As a result, home values increased as new buyers effectively had more money in their pockets to spend on a more expensive house. But when the RBA raises interest rates, the reverse happens: home buyers have to spend more on interest, and so have less to spend on a house.

What 'duration' means

The renewed focus on bond yields has also cast a spotlight on a lesser understood risk in bond markets - duration risk, particularly as cash rates have remained low for so long.

To better appreciate the investment implication of rising interest rates, it is important to understand duration, a measure of risk used to gauge a bond's price sensitivity to interest rate changes, or its interest rate risk. Duration is measured in years.

The closer a bond is to maturity, the lower its sensitivity to interest rate changes. For instance, a duration of one year is likely to lose 1% of its value for every 1% rise in interest rates, but a bond with a duration of 10 years would lose 10% for every 1% rise in rates. (This is a theoretical example only.)

For everyday purposes, estimating the duration of a bond is actually very easy using this trick: it's simply the weighted average of future interest payments and principal. Investors can visualise this as a bunch of sacks of money sitting on a seesaw.

The plank represents the time until maturity. The little sacks are coupons and the big sack at the end represents the final payment of principal. The balance point on the seesaw is the duration.

Strategies to consider

The impact of an interest rate change on the price of a bond or portfolio of bonds varies across maturities and coupons.

This may not be a major issue if an investor intends to hold the bonds to maturity, since the yield at which the initial investment was made is usually a good proxy for the total return over the life of the bond. But it can matter a great deal to investors who are looking to sell their bonds before the maturity of the instrument.

With interest rates continuing to rise, duration risk is a very real concern for bond investors. The risk can be lowered by switching to less interest-sensitive short-term bonds or cash substitutes ahead of an expected rise in interest rates.

Another factor that investors need to take into consideration is their investment horizon (the length of time that an investor is willing to hold the portfolio), especially when reducing duration risk.

A rising interest environment could be good for investors whose investment horizon is longer than the maturity of the bond, as the higher coupon payments they receive over time tend to offset the price of their bond declining. But for investors with a short-term investment horizon, managing the changing or falling bond price is usually the primary focus.

Duration, therefore, allows investors to compare directly bonds of different maturities and coupon rates (the annual income and construct portfolios that are based on how sensitive their price is to interest rates. Investors can change the duration of their portfolio to modify interest rate risk.

Portfolio duration strategies may include reducing duration by adding shorter maturities or higher coupon bonds and increasing duration by extending maturities or including lower coupon bonds.

In practice, bond prices depend on many other variables apart from duration, and interest rates do not move in parallel shifts as the shape and position of the yield curve is constantly changing. Therefore, historical correlations between duration and bonds are imperfect. They should be used as a guide rather than as a forecasting tool. Still, duration management is an important tool for fixed-income investing.

In the current environment, interest rates could rise further as inflation continues to climb. While bond yields have risen, real interest rates - which consider inflation in their calculation - are historically low. Investors need to be aware of further potential duration losses in the present bond yield upcycle that we believe could extend into 2023.

Even if inflation starts to fall back later in 2022, real rates still appear to be too low, judged by the old rule of thumb that the real interest rate should converge over time to the long-run potential growth rate of the economy.

Benefit of active management

As discussed earlier, a potential solution would be for investors to aggressively reduce portfolio duration ahead of an expected increase in yields. Our research suggests that lowering the duration on a portfolio of government bonds to around two years can significantly reduce or even avoid losses.

Another potential solution would be for investors to invest in a flexible global bond strategy, delegating the active duration management decision to a professional portfolio manager. For example, successful country allocation away from benchmark can potentially help to generate positive returns even during periods of rising yields.

In a fixed-income regime where central banks continue to raise interest rates as opposed to cutting them as we've become accustomed to, we think that investors could benefit from active duration management to tackle higher bond market volatility.

Against this backdrop, it is difficult to see how volatility in bond markets will ease anytime soon - on the contrary, we believe it is here for the long term. At a difficult time for markets when the ground is constantly shifting, dynamic management of bond exposures will remain key.

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