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Durations of fixed income indices are moving up rapidly. This is mainly caused by governments and companies locking in cheap financing costs by issuing longer dated bonds. If bond yields were to rise, this could have serious consequences for index-focused or passive investors. In the current low-yield environment we advocate active and flexible duration management.
Fixed income indices are still widely used to benchmark the added value of active managers. A very important characteristic of any fixed income index is the weighted duration. The duration level of a bond index is driven by the maturity of the bonds that have been issued and by other factors like coupon and yield levels.
Figure 1 | Duration and maturity of global government bond market
Source: Robeco, JP Morgan Government Bond Index Global
Robeco research shows that the bulk of this increase in duration, almost 80%, relates to a change in the issuance pattern by debt agencies. Historically low yield levels have triggered a strong rise in the issuance of long-dated bonds, thereby pushing up the average maturity of the debt outstanding (orange line). Governments are locking in cheap funding, thereby reducing refinancing risks. Early May the Spanish government sold bonds with a maturity as long as 50 years for the first time in the public market. One month earlier Belgium had done the same. Italy and Japan are said to consider their own debut 50-year deals. Some Treasuries have gone even a step further. Ireland privately placed a 100-year bond this year.
The increase in duration is visible across a broad set of countries. The UK and Japan are eye-catching; currently, the average duration of their outstanding government bonds has risen to levels close to or above 10 years. In the UK the increase relates to the structural demand for long-dated bonds from investors like pension funds and insurance companies that need to match lengthy liabilities. Also notable is the dramatic increase for countries like Spain and Italy, especially when compared with the late eighties. Joining the euro system has enabled these countries to issue much longer bonds.
Figure 2 | Average durations of various bond categories
Source: Robeco, Barclays POINT
From a borrower’s perspective this all makes perfect sense. But what about investors? For those fixed income investors that tend to follow or even mimic fixed income indices, a potentially toxic combination is in the making. Just as yield levels are falling to unprecedented low levels, durations of most fixed indices are rising fast. In other words, just as interest rate risk in index-related fixed income products is moving higher, compensation for that risk is falling rapidly.
Another way of looking at this, is by focusing on the so called ‘breakeven yield rise’. With that we mean the interest rate rise that is still bearable (due to the positive carry) before the overall return dips into negative territory. This breakeven yield rise has dropped dramatically.
This is not a plea for selling all fixed income exposure. In the short run yield movements tend to be more important for the overall fixed returns than the actual yield levels. The first half of 2016 is a good example. Although yield levels were already low at the start of the year, fixed income returns over the first half of the year were good because bond prices moved up (capital gains were made) as yields moved to even lower levels.
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