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Protection with the Zero-duration share class

11-07-2013 | Insight How can corporate-bond investors protect themselves against a possible rise in long-term interest rates?

Long-term interest rates are more likely to rise than fall. This makes it particularly interesting to invest in the Robeco Zero-duration share class, because bond prices react inversely to yields. Zero duration lowers interest-rate sensitivity. The Robeco Zero-duration share class is created using interest-rate swaps.
  • Yields on US and European government bonds rose after reports that the Fed could begin tapering back its bond purchases;
  • Robeco offers a Zero-duration variant that protects the regular share class against a rise in the long-term interest rates;
  • Some peers in the market offer so-called short-duration funds, but these have serious drawbacks versus our Zero-Duration offering:
  • Robeco offers Zero-duration variants for High Yield Bonds, Investment Grade Corporate Bonds and Financial Institutions Bonds.
Yields rise after Fed policy statements
Yields on US and European government bonds rose after reports that the Fed could begin tapering back its bond purchases later this year if the US economy keeps improving. Figure 1 shows the 5-year German Government Bonds and US Treasury yields (in %).

Currently, the Fed is buying USD 85 billion each month in treasury paper and mortgage-backed securities to stimulate economic and jobs growth. Bond investors expect this to be the starting point of a Fed policy that is less accommodating to the bond market. They fear that the Fed might raise short-term interest rates after 2015 in order to fight inflation.

In the euro zone, the situation is different: the ECB has pledged that interest rates will remain at record lows far into the future. The euro-zone economy is still weak.

Figure 1: 5-year German Government Bonds and US Treasury yields (in %)
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Source: Bloomberg

Zero-duration share class - how does it work?
Robeco offers a Zero-duration variant that protects the regular share class against a rise in the long-term interest rates, while investors can still try to take advantage of higher credit spreads.

The Zero-duration share class invests in the existing portfolio and includes an interest-rate hedge. This hedge lowers interest-rate sensitivity by swapping the 5-year interest rate for the money-market rate (Libor 3 months). This means that Robeco pays the fixed interest rate while receiving the floating interest rate. The result is a lower sensitivity to interest rates. The investor can still benefit from potential credit-spread tightening. The expected returns on high-yield bonds are twofold: the credit spread and the interest rate. The swap makes the interest-rate component variable. When government bond yields rise, the Zero-duration share class is expected to outperform the regular share class.

Implementing this hedge lowers the yield of the portfolio. This difference currently amounts to about 1.5%. As the current duration of the Robeco High Yield fund is around 4.4 years, the interest rates only have to rise by about 35bps in order to break-even between both share classes (duration x rate increase) and to compensate for this yield give-up. In a scenario of stronger rate increases, the Zero-duration share class is expected to deliver higher total returns than the regular share class.

Case study: investing in Robeco High Yield
High-yield bonds offer investors attractive credit spreads: the current US high yield credit spread is 480 bp on government bonds. Figure 2 shows the US high yield credit spread since 1994. But what is the best way to reap the benefits of this credit spread, when long-term interest rates can have a major impact on total returns?

Robeco High Yield Zero Duration offers protection against a further rise in long-term interest rates by exchanging the 5-year swap rate for the 3-months swap rate.

The cumulative performance difference (in %) between the zero and regular high-yield share class is shown in Figure 3 (red line) together with the development of the 5-year swap rate (blue line). They can be seen to have moved more or less in line. The performance of the Robeco High Yield Zero-duration share class versus the regular class can also be seen in Figure 3. The Zero-duration class outperformed the regular share class in recent weeks as a result of increasing interest rates.

The return on a high yield bond corresponds to a yield on a comparable government bond plus a credit spread (higher interest rate) to compensate for the risk associated with a high-yield investment.

The regular Robeco High Yield share class offers a yield of 6.4%, consisting of a long-term interest rate of 1.7% and a credit spread of 4.7%. The sensitivity of the interest rate and of the credit spread is 4-5 years.

The Robeco Zero-Duration share class offers a yield of 4.9%, consisting of a short-term interest rate of 0.2% and a credit spread that is also 4.7%. The sensitivity of the interest rate component is reduced to around zero, while the sensitivity of the credit spread is around five years.

The Robeco High Yield fund manager expects returns in line with yields for the next twelve months of around 6.4% (as per end of June 2013. Following the recent yield increase, he has been adding slightly more risk to the portfolio by adding some bonds that repriced disproportionately. The credit beta of the fund has been increased from underweight to neutral (beta is 1). In the US, there have been outflows in high-yield ETF holdings, represented by predominantly tactical investors. This has been much less the case with actively managed funds like Robeco’s High Yield fund.

The fund manager believes that the search for yield is not over yet, and that investors might add risk to their portfolios once the markets stabilize somewhat. On the back of the relatively weak economy, it remains key to focus within the high-yield universe on the strongest companies able to weather the storm. Robeco High Yield therefore avoids the weakest issuers.

  
Figure 2: US high-yield credit spreads from January 1994 (in %)
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Source: Barclays

Figure 3: Cumulative performance difference (in %) between Robeco High Yield Zero Duration (0DH) and regular Robeco High Yield (DH) and performance of 5-year swaps (in %)
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Source: Robeco

Short-duration fund alternatives have drawbacks
Some peers in the market offer so-called short-duration funds. These funds are invested in bonds with short maturities only. These alternative funds have serious drawbacks versus our Zero-Duration offering:
  • Investable universe is limited. A short-dated bond fund has a smaller investable universe, because it cannot use all maturities. This makes it more difficult to build a well-diversified portfolio. On the other hand, Robeco’s portfolio manager can select long-duration bonds if they are attractively priced. This increases the opportunity for alpha generation.
  • Illiquidity. Short-dated bonds tend to be subject to less liquid trading. This can lead to higher trading costs.
  • Higher call risk. This risk (i.e. that a bond issuer will take advantage of the callable bond feature and redeem the issue prior to maturity) is more prominent in bonds with shorter maturities. The higher call risk leads to an uncertain risk/return profile and interest-rate sensitivity.
  • Lower yields. Short-duration bond funds offer considerably lower yields on the portfolio compared to the Robeco Zero-duration share classes.

A switch from the regular share class to the zero-duration share class is easily done without any buying or selling of bonds, simply by trading in the interest-rate swap, a highly traded financial instrument.

The Zero-duration strategy is implemented by state-of-the-art systems with a strong focus on operational and financial risk management. Robeco’s risk-management system includes the use of derivatives, and risk is measured on a daily basis.

Robeco offers Zero-duration variants for High Yield Bonds, Investment Grade Corporate Bonds and Financial Institutions Bonds. Robeco can also offer tailor-made solutions to decrease duration.

Interested in what the Zero-duration share class can do for you? Please contact your account manager to check availability

For professional investors only. The value of your investment may fluctuate. Past performance is no guarantee of future results.

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