The duration element is often missing from investor portfolios, and different fixed-income assets have different duration characteristics, Chris Dickman, portfolio manager at boutique fixed-income manager Altius, said.
Principal Global Investors Australia chief executive Grant Forster broadly agreed duration could too often be overlooked in management of fixed-income portfolios – to investors’ detriment.
Dickman said most term deposits, for instance, had no duration benefits. To illustrate this, he compared the return of a typical bond and term deposit.
“The yield of a 10-year bond was 4 per cent at the start of March this year and fell to 3 per cent by the end of May. This is a return of approximately 9 per cent over that period,” he said.
“In comparison, a three-month term deposit with a seemingly more attractive headline rate of 5 per cent per annum returned just 1.25 per cent over that time – more than 7 per cent less than the bond return.”
Forster said Principal Global Investors had “looked at this issue from our investors’ perspective late last year”.
“The fact is that when your fixed income is linked to a cash or cash plus benchmark, you tend to manage with zero or very low duration,” he said.
“As a consequence, when rates fall, you are not able to add to performance, because you have this short duration. Add to this the fact that rates tend to fall at times when economies are falling and you have a double conundrum, because companies tend to be doing it tough during these periods. This means that credits come under fire when things slow down.”
Dickman said the key to successful investing in fixed income was to consider the asset class from a return perspective, rather than yield. Crucially, this meant understanding that return was a function of a change in yield, not just the yield itself.
“The different fixed-income assets generate different returns. For example, when interest rates rise modestly, longer-term government bonds may endure a negative return at the same time as corporate bonds enjoy a positive return. Over the last 10 years, in fact, corporate bonds have outperformed Australian government bonds by around 10 per cent,” Dickman said.
“Analysis of monthly returns shows corporate bonds outperform government bonds 72 per cent of the time and on average outperform by 22 basis points per month.
“Conversely, when government bonds do outperform corporate bonds, the average outperformance is 37 basis points, highlighting that active sector allocation is a critical tool to exploit superior return opportunities.”
Forster said Principal Global Investors allowed for both increases and decrease to duration, in essence providing the manager with an extra lever to manage performance dependent on market conditions.
“We have found that adding levers, rather than taking them away, gives us the control and flexibility to take advantage in times when rates are falling and, conversely, when they rise. For that reason we have moved away from a cash plus benchmark to a corporate bond benchmark with closer to five years’ duration,” he said.
“We’ve had a very good year. As interest rates have continued to come down, having the flexibility for longer duration has worked in our favour. This is simply because the value of bonds goes up if interest rates decline. In addition, corporate spreads have generally tightened, which has also contributed to performance.”
The safeguard must equally apply in reverse, he said. “Conversely you also need to be prepared for interest rates to rise – sometimes dramatically. If you have a significant exposure to duration as they do so, you have risk of underperforming. So the key, as a fund manager, is to have the tools to operate to both shorter and longer durations,” he said.
