The sensitivity of a Central Bank’s monetary decision, primarily in terms of rate hikes, has a huge impact on a portfolio’s performance, both on the upside and on the downside. Not going too much into the technical detail, a portfolio’s modified duration indicates the portfolio’s sensitivity to a move in interest rates.

A practical example - given that a portfolio has a modified duration of three, technically speaking, a 1 per cent rate hike should impact negatively the portfolio by 3 percent. The reversal is also implied. As a reminder, modified duration follows the concept that interest rates and bond prices move in opposite directions.

The current market environment

In the second half of 2018, expectation of rate hikes increased and this is one of the reasons, apart from the geopolitical tensions, we saw credit markets experiencing the first negative year in decades. Thus, in line with the technical principle, portfolio managers who had a high portfolio duration were experiencing a higher negative movement to those who a held a lower duration.

Indeed, the persistence of the Federal Reserve (Fed), to increase rates in December, has exuberated the movement in yields with US investment grade bonds being the prime losers within the credit space, followed by the more risky assets. In fact, in December we were seeing very high quality credit names being harshly hit as expectations of a hike increased.

Today, we are seeing a reversal following the change in stance by the leading central banks. In fact, following the announcement by the Fed of a more dovish stance in terms of hikes, we experienced a notable re-pricing in credit markets. Indeed, on a year-to-date basis US IG credit is close to 3 per cent, while US HY is up 6 per cent.

In line with the duration concept, the recent change in monetary stance to a more accommodative one has led to a relatively good performance on a year-to-date basis. Moreover, those investors who had the vision to increase their portfolio duration are benefitting from higher returns, compared to those who held a low modified duration. Let’s not forget that markets move on expectations and thus the probability of no rate hikes have triggered the recent positive moves.

Moving forward, growth figures have been revised downwards globally. In this regard, the more patient stance by monetary policymakers gives credit investors leeway to increase their portfolio durations.

Indeed this is what we have been doing over the past days: increasing our portfolio duration in order to capture the implied the higher return. We believe that in the short-to-medium term we should see a prolonged accommodative stance and thus this gives credit investors the opportunity to lock higher returns by taking longer term risks - not specific credit risk, but maturity risk in this case.

Disclaimer:

This article was issued by Jordan Portelli, investment manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, view 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.