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Active duration management crucial as US yield tops 3%

Active duration management crucial as US yield tops 3%

26-04-2018 | Insight

Government bond yields are on the rise globally as central banks tighten their policies and global economies continue to accelerate. The rise in yields is most pronounced in the US, where the 10-year Treasury yield exceeded the 3% level in late April. Investors need to find ways to protect the value of their bond allocation. This is exactly what Robeco QI Global Dynamic Duration aims to do by reducing duration when yields rise and increasing it when they decline. In the first quarter of 2018, based on signals given by Robeco’s quantitative duration model, the fund took underweight duration positions to protect its investors from the rising yields in global bond markets. The underweight position in the US has been in place since the third quarter of 2017.

  • Olaf  Penninga
    Olaf
    Penninga
    Senior portfolio manager fixed income
  • Johan Duyvesteyn
    Johan
    Duyvesteyn
    Senior Quantitative Researcher and Portfolio Manager

Speed read

  • Federal Reserve tightens amid strong growth and rising inflation
  • 10-year US Treasury yield exceeds the 3% level
  • Dynamic Duration offers protection as bond yields rise

Active duration positioning

Robeco QI Global Dynamic Duration can increase or reduce its duration (interest-rate sensitivity) by a maximum of six years, equally divided over the US, Germany and Japan (two years per country). The active duration positioning of the fund is fully driven by our quantitative duration model. This model uses financial-market data to capture the expectations for fundamental drivers of bond markets coupled with well-documented factors like valuation and trend.

The fund’s duration at the start of 2018 was as low as 2 years. This six year underweight versus the benchmark is the result of underweights in the three main government bond markets: the US, Germany and Japan. The model forecasted rising yields in all markets. Strong economic growth had broadened from the US to the rest of the world and growth expectations were boosted further as the US tax cuts took effect. Rising commodity prices pointed to higher expected inflation. The Fed was also expected to continue hiking interest rates and the trend in global bond markets turned negative.

The fund’s underweight position in the US has been in place since Q3 2017

The model remained underweight in the US, driven by a further rise of commodity prices pointing to higher expected inflation, an expected continuation of rate hikes by the FED and the unattractive valuation of US treasuries as short rates moved up steadily leading to a flatter yield curve.

The quantitative model performs well when yields rise

The Dynamic Duration management has demonstrated its ability to protect against rising yields since its implementation exactly 20 years ago. As the past two decades have been characterized by generally declining yields, there have been more opportunities to add value by benefiting from falling yields than by protecting against rising yields. To assess the performance in longer periods of rising yields, we extended the strategy’s backtest to include the 1960’s and the 1970’s. The results are clear: the model also performs well in prolonged periods of rising yields, such as the bond bear market of the 1970s. Furthermore this study confirms that the model generally performs best when markets move significantly, both in periods when yields decline and when they rise.

Outperformance when you need it most

As this strategy actively times its bond market exposure, it requires meaningful moves in yields to be able to add value. When yields lack direction, as was the case in 2017, the fund tends to perform less strongly. To underline the strategy’s ability to perform at its best when yields move most, we first analyzed the worst ten calendar quarters for bond markets since the model was introduced in the fund in 1998 and found that in 9 out of 10 of these quarters, the strategy indeed offered protection. The average outperformance in these 10 quarters was 0.92% per quarter (not annualized). We then also looked at the 10 worst quarters for equity markets. When equity markets fell, the strategy worked particularly well too. In this case, the fund offered 1.48% extra return per quarter (not annualized) on top of the already strong government bond return. The fund’s average annualized outperformance since the quantitative model was introduced in 1998 is more than 0.80%1 .

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Impressive outperformance in the worst quarters for bond and equity markets

This special feature – the ability to perform strongly when yields rise and when equities suffer – sets the fund apart from its peers. It is the only fund in its peer group that outperforms in both environments, while other funds generally outperform either in equity downturns (funds with high government bond exposure) or when bond markets decline (funds with high credit exposure), but not in both environments.

Conclusion

Now that government bond yields are on the rise, especially in the US, investors are looking for ways to protect the value of their government bond portfolios. Robeco QI Global Dynamic Duration aims to do just that – offering protection against rising yields by reducing its interest rate sensitivity to less than 2 years. The fund can also benefit strongly from falling yields by increasing its duration to nearly 14 years. In early 2018, the fund took its lowest possible duration position, offering its investors protection from the rising yields in global bond markets. The US underweight duration position has contributed strongly to the fund’s performance since it was taken in the third quarter of 2017. Research indicates that the model tends to perform best when yields move most. An extended backtest shows that the duration model performs equally well in periods of rising and declining bond yields. The Dynamic Duration strategy is thus uniquely well-placed to offer investors the protection they are looking for in today’s challenging bond market environment.

This article was originally published on 05/02/2018

1All returns mentioned are gross of fees and based on Robeco QI Global Dynamic Duration DH EUR share. In reality costs (such as management fees and other costs) are charged. These have a negative effect on the returns shown. Benchmark: J.P.Morgan GBI Global Investment Grade (EUR). The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future.

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