Duration management is key to bond returns

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.”

“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.”

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).