Active management of bond duration can protect against any future rate rises while still generating returns if yields continue to fall, says Robeco’s Olaf Penninga.
The prospect of the first US rate rise in almost a decade has caused many government bond investors to believe that they now face declining or negative returns. Bond yields and prices move inversely, which means that if rates do rise, and yields rise in tandem, then bond values would fall.
By focusing on duration, or the amount of time before the bond matures, investors can adjust the interest rate-sensitivity of their holdings, says Penninga, portfolio manager of the Robeco Lux-o-rente government bond fund. Shorter-dated bond values are generally less sensitive to rate rises than longer-dated ones.
Lux-o-rente uses a duration management quantitative model as its sole performance driver. An overlay of liquid interest rate futures is added to an underlying portfolio of global government bonds to steer the duration profile of the portfolio. The model predicts interest rate moves in the three main bond markets; Germany, Japan and the US. The strategy was designed to be able to strongly benefit from falling interest rates and protect against rising interest rates.
Markets reacted positively to a meeting by the US Federal Reserve (Fed) on March 18 at which members of the rate-setting Federal Open Market Committee gave their strongest indication yet that rates would rise this year for the first time since 2006. Crucially, Fed chairwoman Janet Yellen said the US central bank no longer needed to be ‘patient’ about when to start hiking rates, though she stressed that they didn’t need to be ‘impatient’ either.
“Many investors worry about rising yields as the Fed prepares to start hiking rates,” says Penninga. “Yellen has stressed that the removal of “patience” from the Fed’s statement need not imply a rate hike as early as June, but the Fed might very well start raising rates this year.”
“While the Fed will probably not raise rates in a straight line to over 5%, like they did in 2004-2006, a somewhat more modest tightening cycle could potentially also hurt government bond markets. In 1999 the Fed embarked on a series of rate hikes totaling 1.75%. From current levels, that would take the Fed Funds rate just to 2%. However, the anticipation of that tightening pushed US 10-year bond yields up by 1.8% in 1999.”
‘Many investors worry about rising yields as the Fed prepares to start hiking rates’
“In today’s low-yield environment government bond markets are more vulnerable to rising yields,” he says. “Firstly, the relatively low level of yields offers little buffer to cushion price declines of bonds. On top of that, the average duration of government bonds has increased in recent years as countries have issued more long-dated bonds.”
“Therefore, actively controlling interest-rate risk is thus crucial. With its outspoken duration management Robeco Lux-o-rente is well-suited for today’s challenging market environment.”
The Lux-o-rente fund achieves this by buying bonds to achieve a portfolio duration that can deviate from the benchmark average of seven years by minus-six years to plus-six years in either direction. In this way, the duration positioning of the fund varies from one to 13 years.
“By reducing duration it can protect against rising yields,” says Penninga. “The duration management is fully based on the outcomes of our proprietary quantitative model, which has demonstrated its market timing ability since the late 1990s. The 1999 rise in bond yields for example was correctly anticipated by the model. This market timing ability is crucial for successful duration management.”
‘Actively controlling interest-rate risk is crucial’
Markets have been afraid of rate hikes before. After the financial crisis in 2008, investors originally expected a Fed rate hike when the worst of the crisis had blown over in late 2009, when nothing happened. “Reducing duration too early would have meant missing out on great bond returns,” says Penninga.
He says the duration model really proved its worth when the Fed conducted its last act of tapering bond purchases in October 2014, and many investors expected rates to start rising. In fact, yields fell further, and US government bonds returned 6% over the six-month period around the decision (31 July 2014 – 31 January 2015).
“Over this period, Robeco Lux-o-rente had overweight duration positions, thus benefiting strongly from the rally in bonds,” says Penninga. “This underlines the advantage of the disciplined implementation of the quantitative model’s signals. The model forecasted lower bond yields for good reasons – like rapidly declining inflation putting pressure on central banks around the world to ease policy further.”
“Nevertheless, not many investors expected government bonds to perform well. Actually, the consensus view instead was that bond yields were so low that bonds were quite unattractive. Our model also takes the valuation of bond markets into account, but it decided that the macro environment called for even lower yields. By ignoring the emotional belief that ‘bond yields cannot go lower’, Robeco Lux-o-rente was able to benefit strongly from the rally in government bond markets.”
One of the advantages of the fund’s quantitative approach is that it allows researchers to back test what happens in different market environments, like the strong rise in bond yields in the 1970s. “The long-dated back test confirms that the model performs as well with rising yields as with falling yields,” says Penninga. “It also reveals that the model has actually performed best when bond yields made bigger moves, whether rates are rising or falling. This is a useful property as this is precisely when one needs active duration management the most.”
The content displayed on this website is exclusively directed at qualified investors, as defined in the swiss collective investment schemes act of 23 june 2006 ("cisa") and its implementing ordinance, or at “independent asset managers” which meet additional requirements as set out below. Qualified investors are in particular regulated financial intermediaries such as banks, securities dealers, fund management companies and asset managers of collective investment schemes and central banks, regulated insurance companies, public entities and retirement benefits institutions with professional treasury or companies with professional treasury.
The contents, however, are not intended for non-qualified investors. By clicking "I agree" below, you confirm and acknowledge that you act in your capacity as qualified investor pursuant to CISA or as an “independent asset manager” who meets the additional requirements set out hereafter. In the event that you are an "independent asset manager" who meets all the requirements set out in Art. 3 para. 2 let. c) CISA in conjunction with Art. 3 CISO, by clicking "I Agree" below you confirm that you will use the content of this website only for those of your clients which are qualified investors pursuant to CISA.
Representative in Switzerland of the foreign funds registered with the Swiss Financial Market Supervisory Authority ("FINMA") for distribution in or from Switzerland to non-qualified investors is Robeco Switzerland AG, Josefstrasse 218, 8005 Zürich, and the paying agent is UBS Switzerland AG, Bahnhofstrasse 45, 8001 Zürich. Please consult www.finma.ch for a list of FINMA registered funds.
Neither information nor any opinion expressed on the website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. An investment in a Robeco/Robeco Switzerland AG product should only be made after reading the related legal documents such as management regulations, articles of association, prospectuses, key investor information documents and annual and semi-annual reports, which can be all be obtained free of charge at this website, at the registered seat of the representative in Switzerland, as well as at the Robeco/Robeco Switzerland AG offices in each country where Robeco has a presence. In respect of the funds distributed in Switzerland, the place of performance and jurisdiction is the registered office of the representative in Switzerland.
This website is not directed to any person in any jurisdiction where, by reason of that person's nationality, residence or otherwise, the publication or availability of this website is prohibited. Persons in respect of whom such prohibitions apply must not access this website.