Forum A meeting place for views and ideas What are you missing out on? Duration exposure the gap in many fixed income portfolios. Published October 2012 Robert Moore Research Analyst, Fixed Income Russell Investments Clive Smith Portfolio Manager Russell Investments
What are you missing out on? Duration exposure the gap in many a fixed income portfolio. When a retail investor is asked about the domestic fixed income market, the two talking points that are most commonly mentioned are term deposits for safety and hybrids for additional yield. To some degree this bias is understandable, clearly being driven by the relative accessibility of these two segments of the fixed income space. for the first time, retail investors will have access to a dimension of fixed income management which has long been available only to their institutional counterparts. However with the recent changes to ASIC s rules regarding the listing of Bond ETFs, access is now available to the full spectrum of standard fixed income securities. One new dimension to the management of fixed income portfolios that has thus been introduced as a result of bond ETFs is the important concept of duration. The significance of this is that for the first time, retail investors will have access to a dimension of fixed income management which has long been available only to their institutional counterparts. The aim of this paper is to highlight how duration is the missing piece in fixed income portfolios and how it can be utilised to achieve a more balanced and complete exposure to fixed income markets than was previously available to retail investors. What is duration? Let s start by asking the simple question: What is duration? To better understand the concept of duration, consider that when an investor lends money to an issuer (borrower) in the form of a bond, the issuer sets out a repayment schedule, which outlines the timing and size of each cash flow to be paid to the investor. The average length of time it takes to receive back the PRESENT value of the initial loan is known as duration. Generally speaking, the duration increases as the termto-maturity of a bond lengthens and/or the size of the regular coupons received decreases. The importance of duration is that it measures the sensitivity of the value of the bond to changes in interest rates. Put another way the longer the duration of a bond, the more sensitive its value is to changes in interest rates. Importantly the relationship is inverse, meaning that as interest rate fall (rise), bond prices rise (fall). So why is duration useful in a fixed income portfolio? The usefulness of duration as a fixed income exposure is that it: a) Allows investors to take explicit views regarding the outlook for interest rates and b) Can have a risk reducing impact on fixed income portfolio returns owing to its inverse relationship with credit risk. It is this second impact which this paper seeks to address and we will now turn to examine the concept in more detail. 1
To understand how this relationship between duration and credit works, imagine a situation where an economy is entering an economic boom. In such a scenario where the broader economy and corporate profits are growing, interest rates generally rise while credit risk declines. Alternatively, if the broader economy enters a period of decline, credit risk (risk of default) generally increases, and under most circumstances this type of economic stress period will be accompanied by falling interest rates. Accordingly, over the cycle the credit risk and duration within a portfolio often combine to assist in smoothing the potential volatility in return when credit spreads are widening, the negative impacts of this declining of bond prices are often offset by falling outright interest rates. Alternatively, when rising interest rates negatively impact on bond prices, it is often the case that part of this negative effect is again offset by contracting credit spreads. It is useful to have a closer look at the relationship between duration and credit risk. While the strength of the relationship will vary over time, it is generally strongest during times of material financial or economic uncertainty. This is an important consideration for investors as these are the times in which it can be most difficult to actively manage downside credit risk using just term deposits. An example of such a period is the time since the onset of the global financial crisis. While this period may be considered extreme, it does highlight the diversifying benefits of combining duration and credit risk. Chart 1 plots the rolling 1 year return for the Elstree Hybrid Index, the UBS Treasury Index (5-10 Yrs) and Term Deposits (TDs) rate from 2007 to 2012. An important point to note is that the Elstree Hybrid Index has negligible duration as most of the securities are floating rate notes and hence capture the market s perception of credit risk. In contrast, the UBS Treasury Index (5-10 yrs) comprises negligible credit risk and hence its returns reflect the impact of duration. While this period may be considered extreme, it does highlight the diversifying benefits of combining duration and credit risk As the returns over the period from 2007 to 2012 highlight, the duration and credit risk can move inversely during periods of heightened economic uncertainty and accordingly can assist in smoothing out returns. Such defensive characteristics are not available from term deposits, as they generally possess relative low durations. This relationship between credit risk and duration accordingly provides investors with an additional lever with which to manage overall risk within their fixed income portfolios. Chart 1: Duration (UBS Treasury Index), Credit (Elstree Hybrid Index) and Term Deposits 1 Year Rolling s 50% 40% 30% 20% 10% 0% -10% -20% -30% 2007 2008 2009 2010 2011 Year Elstree Hybrid Index Term Deposits UBS Treasury index (5-10) Source: RBA, UBS Investment Bank, Elstree Investment Management The rolling returns are indicative of beta/passive exposures to term deposits, ASX-listed hybrids and 5-10 year Commonwealth Government securities. Indexes are unmanaged and cannot be invested in directly. Past performance is not indicative of future results. 2
How does duration add another dimension to a portfolio? To further flesh out the use of duration as an additional lever let s consider the process of structuring a portfolio for a retail investor. As a starting point, a retail investor can begin with a risk free investment. For many investors term deposits are the default risk free investment of choice as shown in Chart 2. The caveat we would add to this is that in our opinion, the term risk free applies only to short term TDs; i.e. those with a term to maturity of no more than 180 days. For an investor seeking higher returns, they could now decide to allocate some of their assets from the risk free sub portfolio to a higher yielding and riskier sub portfolio (referred to as the fixed income sub portfolio) in Chart 3. Up until now an investor wanting to enhance returns had limited options and so had to rely on debt hybrids as being a key part of any Fixed Income sub portfolio. The issue is that as the investor allocates funds to such a fixed income sub portfolio in order to earn higher returns in line with longer term investment objectives, they face the risk of having a portfolio which is over exposed to credit risk. When an investor wishes to aggressively shift their allocation, the prevailing market conditions may inhibit their ability to effectively pursue the strategy Chart 2: free (Term Deposits only) Term Deposit Free Fixed Income Chart 3: free Sub Portfolio + Fixed Income (Hybrid only) Term Deposit Free Hybrids Fixed Income One option available to the retail investor is to balance this by proactively altering the allocation between risk free and fixed income sub portfolios, so as to maintain an appropriate exposure to credit risk over shorter time horizons. In practice, while this may seem a viable strategy there are some issues. Firstly, it requires the investor to be able to have a very solid understanding of the prevailing credit environment in order to appropriately assess the required allocation. Secondly, it assumes ongoing liquidity in the assets comprising the fixed income sub portfolio. The issue is that when an investor wishes to aggressively shift their allocation, the prevailing market conditions may inhibit their ability to effectively pursue the strategy. This is particularly relevant for hybrid securities which exhibit characteristics of both debt and equity capital and are generally complex and highly structured instruments. It is for this reason that the addition of duration exposure to the fixed income sub-portfolio can be utilised to help balance out the credit allocation, as shown in Chart 4. The addition of a duration exposure provides the investor with additional diversification/risk reduction within the fixed income sub portfolio. The addition of the increased duration exposure provides a potential offset to the hybrid security s heavy credit exposure in the event of a material increase in economic uncertainty. Chart 4: free Sub Portfolio + Fixed Income Sub Portfolio (Hybrid & Duration) Term Deposit Free Duration Hybrids Fixed Income Examples are for illustrative purposes only and should not be construed as investment advice. 3
Conclusion With the introduction of bond ETFs, investors have been given the opportunity to add an additional dimension to their portfolio s opportunity set: that of duration. Even if investors do not have definite views regarding the outlook on interest rates, adding duration can provide diversification benefits when combined with credit exposures within an investor s portfolio. Such diversification benefits can provide a useful counterbalance to assist in smoothing returns during periods of heightened financial volatility and uncertainty. For this reason, investors should view duration as an additional building block within their portfolios to assist in achieving greater balance with respect to fixed income exposures and returns. For more information contact Robert Moore Research Analyst, Fixed Income Australasia +61 2 9229 5546 rmoore@russell.com Clive Smith Portfolio Manager, Sydney +61 2 9229 5407 crsmith@russell.com 4
For more information contact Russell: Phone Sydney 02 9229 5111 Melbourne 03 9270 8111 Website www.russell.com.au Address Level 29 135 King Street Sydney NSW 2000 This document is issued by Russell Investment Management Ltd ABN53 068 338 974, AFS License 247185 (RIM). It provides general information only and has not been prepared having regard to your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation or needs. This information has been compiled from sources considered to be reliable, but is not guaranteed. Past performance is not a reliable indicator of future performance. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. Copyright 2012 Russell Investments. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from RIM. Copyright 2012 Russell Investments. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. MKT/4913/0912. R_NEWS_Forum_Duration_V1FF_1210