(July 25, 2013) — Many investors are only getting half of the story when asking about bond duration-and this is hurting their portfolio, fixed income specialist TwentyFour Asset Management has claimed.
Since the US Federal Reserve Chairman Ben Bernanke began hinting about tapering the nation’s quantitative easing programme earlier this summer, investors have been clamouring to know how their bond holdings might be affected.
“Duration itself is a fairly simplistic topic,” said Mark Holman, CEO at TwentyFour, “it is basically a measure of sensitivity of a bond’s price to a change in interest rates. So, generally the longer the bond or the average life of the bonds in the fund, the more price sensitive to interest rate moves it becomes.”
Fund managers have been reducing duration in their bond portfolios, but Holman said understanding how they have done so is vital for investors to know, as most will not just have sold long-dated bonds and bought shorter ones.
Investors should ask about the main components of duration exposure, and understanding a portfolio’s interest rate duration versus its credit duration, amongst other elements, is equally important.
“In many cases [fund managers] have portfolios of bonds consisting of several hundred securities, the aggregate of which will give them the largest component of their duration exposure,” said Holman. “These days fund managers have a broad range of investment tools at their disposal-such as futures and derivatives-that are far more efficient for managing large portfolio; however it does mean that two portfolios with exactly the same duration can perform very differently.”
Holman presented two portfolios with a similar duration profile, but contained hugely different underlying products that were subsequently either defused or intensified by hedges, swaps or other instruments.
Despite initial appearances, the portfolios would react very differently in the same environment.
And there is another issue investors should note.
“All hedges cost money and typically result in a drop in yield,” said Holman. “This is also a big consideration for the fund manager as yield protects the portfolio from these upward movements. How much yield is the manager willing to spend to bring down the duration of his portfolio? And is that money well spent? Very long-dated hedges bring duration down quickly and cheaply, but are also often a long way from where the bonds sit, so these hedges carry a much bigger risk to those that are focussed on parts of the curve that are similar to the bonds that are held.”
The devil, as ever, is in the detail-the duration conversation may end up being a long one.
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