Expectations of Federal Reserve (Fed) rate hikes in 2017 have now increased as opposed to the previously expected, while in Europe some sort of indication of tightening going forward seems to be justified. Thus as markets commence pricing prior action, fixed-income investors’ should give the necessary importance in realigning their portfolios accordingly, mainly in terms of duration.
Unfortunately few investors give the necessary importance to the duration concept. Initially investors should make a distinction between the tenor of a bond or a bond portfolio and ‘modified duration’. The former is basically years to maturity, while the latter is the sensitivity of a bond’s price to movements in interest rates.
The major implications are brought about by ‘modified duration’, which impacts the capital of the investor through price movements. For instance, let’s assume that a bond fund has an average modified duration of 4.5 years. This would imply that a 1 per cent rise in interest rates which impact the bond fund negatively by 4.5 per cent. Thus in such case the investor would see an erosion of capital of 4.5 per cent.
Active bond funds, which are managed by professionals tend to manage the portfolio’s ‘modified duration accordingly, in line with interest rate expectations. This is crucial for investors’ as in times of rising interest rate expectations bond funds with long modified duration would suffer.
Currently, globally bond index funds has an average duration of 7.5 years, while actively managed bond funds have an average modified duration of 5.8 years. On the contrary, the gap for passive and active bond funds in the U.S is quite close, with modified durations of 4.9 years and 5.4 years respectively.
The issue is that actively managed funds can adjust instantly, while passive funds are only adjusted on their re-basing date, usually quarterly.
The current scenario in Europe and the U.S. offers differing prepositions to some extent, despite in the former’s case the recent monthly reduction in quantitative easing was brought about by increased inflation expectations. In my view, the situation in Europe is one in which rising interest expectations are currently unheard of.
That said, as I have mentioned earlier the recent tweak in the ECB’s monetary policies seems to be pointing towards a tightening phase, if data remains on the up-tick. As seen, primarily sovereign bonds are digesting negatively the recent ECB announcement and despite the recent gains of circa 3 per cent, the long-dated sovereign curve has plunged by just below 10 percent since September.
The situation in the U.S. in terms of interest rate hikes seems to be diverging towards a different path with expectations for 2017 increasing to three rate hikes, now more than ever being sustained by positive economic data.
In the U.S. the recent market implications of an interest rate hike were experienced recently. Some market participants believed that the Fed would hike in December and thus commenced reducing their exposures to USD dollar bonds.
In addition, the increased expectations to three rate hikes in 2017 saw the 10-year U.S. Treasury hit yield hovering at the 2.6 percent levels. U.S. High yield debt was also impacted with a decline by circa 0.4 per cent, while it re-gained 0.85 per cent following the meeting.
My major concern going forward is primarily in Europe, in which we should experience a further reduction in QE, if inflation data remains positive going forward.
In this regard, I once again point out the importance of reducing long-dated issues with low coupons from portfolios. Locally, over the past years investors tended to hold local Malta Government bonds as these offered comfort. Going forward the situation seems to be changing and thus one should be prudent and reduce long dated fixed-income holdings, as the duration concept will bite.
This article was issued by Jordan Portelli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.