How to achieve attractive bond returns in a low-yield environment?

How to achieve attractive bond returns in a low-yield environment?

21-06-2016 | Insight

Actively managing a portfolio’s sensitivity to interest rate movements is crucial for the returns on fixed income portfolios, as they are predominantly driven by changes in government bond yields. To forecast yield changes, Robeco developed a quantitative model in the 1990s, which has proven to have very good predictive power.

  • Johan Duyvesteyn
    Senior Quantitative Researcher and Portfolio Manager
  • Olaf  Penninga
    Portfolio Manager
  • Martin Martens

Speed read

  • Changes in government bond yields are the key driver of bond returns
  • The duration model can generate returns as long as yields move
  • The model works well in times of rising and falling yields, and with steep and flat yield curves

The quantitative duration model has determined the duration positioning of Robeco Lux-o-rente since early 1998, enabling it to generate attractive returns and protect its investors against rising yields. We prefer a quantitative approach as the disciplined implementation of a quantitative strategy avoids well-known human behavioral biases and can even benefit from them, when emotions have caused markets to drift away from fundamentals. The ‘anchoring bias’, for instance, is visible when investors state that ‘yields cannot fall further’ as they ‘are already so low’. We therefore follow the model’s signals strictly and never overrule it.

Robeco’s quantitative duration model forecasts the direction of the main developed government bond markets: the US, Germany and Japan. Its forecasts are based on fundamental drivers of the bond market, combined with valuation and technical indicators like trend. The model uses financial-market data to capture the expectations for the fundamental variables growth, inflation and monetary policy.

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Investment strategy: Robeco Lux-o-rente

We implement the model signals in Robeco Lux-o-rente with government bond futures. If the model is positive for a market, we increase the portfolio’s duration by 2 years. Vice versa, if the model is negative for a country we reduce the portfolio duration by 2 years. The total duration exposure of the fund can deviate by six years from that of the global government bond index. As this index currently has a duration of ca 8 years, the fund’s duration can range from 2 to 14 years.

From January 1998 to February 2016 the annual return of Lux-o-rente is 6.0% per year, against 4.9% for the benchmark. This amounts to an outperformance of 1.1% per year with a tracking error of 2.5%. The duration model’s information ratio is 0.5 over more than 18 years. We can justifiably conclude that the model has very good forecasting power and has added significant outperformance.

Good performance in various market conditions

The duration model generally works well across a wide variety of economic and market circumstances – with rising and falling yields, with steep and flat yield curves, in economic expansions and recessions, etc. The model signals deliver most value when bond markets really move – which is precisely when market timing is needed most.

All research on the duration model is conducted by our quantitative researchers in close collaboration with portfolio managers. This ensures that all decisions are based on rigorous quantitative back-testing, combined with deep fundamental knowledge and practical investment experience. The lead portfolio manager for Robeco Lux-o-rente, the head of the Global Fixed Income Macro team and the researchers most involved with the model (including the head of Allocation Research) have been working together on this strategy for more than 10 years.

For more information about the duration model, read the white paper 'Robeco's Duration Model' written by Olaf Penninga, Kommer van Trigt, Martin Martens and Johan Duyvesteyn.

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