Investors in fixed income have historically been able to rely on a series of 'rules of thumb' when thinking about interest rate risk.
Generally speaking, investors uncertain about the path of interest rates and inflation tend to stick with shorter duration bonds as a way to mitigate this risk, while those whose greatest conviction is that an economic downturn is coming will try to be longer duration, as they expect policymakers to cut interest rates in order to stimulate economic growth, and bonds that have higher yields already locked in would be expected to rise in price.
But in a world where economic growth declines, but inflation persists, investors are therefore presented with a dilemma around whether to be short or long duration.
A representative of Pimco says: “Duration is a measure of the weighted average time it takes to receive the cash flows from a bond, including both coupon payments and the return of principal, and is an estimate of how sensitive a bond’s price is to changes in interest rates.
"Bonds with longer durations are more sensitive to interest rate changes, while bonds with shorter durations are less sensitive. This market uncertainty is compounded by the technical features of the present government bond market, with central banks selling assets at the same time as governments are issuing more debt.”
Data from FT Adviser’s sister publication Asset Allocator indicates that most strategic bond fund managers were wrong about duration in 2022, as most were long, and pricing in a recession, while inflation and interest rate rises persisted, and so it was short-duration bonds that performed better.
And since the summer of 2023, many investors have been caught the wrong side of duration, with short-duration bonds doing better despite the deteriorating economic outlook.
Matthew Rees, head of global bond strategies at L&G Investment Management, says the key to managing interest rate risk in a portfolio is less about getting the direction of the economy or interest rates right now, and more about “understanding what the market is worried about at any particular time, because market sentiment will be moving prices in the short term”
He says: “I wouldn’t want to have a lumpy portfolio right now," that is, owning a small number of investments, rather than being diversified. "I also think that while interest rate risk is something people are very focused on, there are opportunities available as well in credit markets, and that diversification is another way to think about interest rate risk.”
Chris Chapman, managing director – fixed income team at Manulife Investment Management, expands on this point. He notes one way to manage interest rate risk is via the geographical exposure of a portfolio.
