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Bonds funds, the duration concept and the current scenario

Unfortunately, few investors give the necessary importance to the duration concept. Initially investors should make a clear distinction between ‘duration’ and ‘modified duration’. The former is basically the duration of the bond, i.e. years to maturity, also known as the bond tenor, 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. This would imply that a one per cent rise in interest rates would 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 modified duration of 7.5, while actively managed bond funds have an average ‘modified duration’ of 5.8. On the contrary, the gap for passive and active bond funds in the US is quite close, with modified durations of 4.9 and 5.4 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 US offers differing prepositions in terms of the ‘modified duration’ concept. In my view, the situation in Europe is one in which rising interest expectations are currently unheard of. The recent downward revision by the European Central Bank (ECB) in terms of inflation numbers further confirms that the ECB has no intention whatsoever to indicate a rate hike. Thus in such circumstances, I would tend to seek further returns by being invested in bond funds that currently hold long ‘modified duration’.

Conversely, the situation in the US is diverging towards a different path with the expectations of a rate hike in December now being sustained within the latest comments by the Federal Reserve (Fed).  Thus investors should look at the ‘modified duration’ on their current USD bond fund investments.

The recent market implications of an interest rate hike were experienced recently. Some market participants (34 per cent as at September 1) believed that the Fed would hike in September and thus commenced reducing their exposures to USD dollar bonds. In fact, prior the Fed meeting on average the 10-year US Treasury hit yield levels of circa 1.7 per cent, while following the announcement of a ‘no rate hike’ decision the same yield fell to 1.63 per cent levels. This was also being reflected in US high yield debt which declined by circa 0.4 per cent, while it re-gained 0.85 per cent following the meeting.

As I have pointed out in my previous articles few weeks ago, I would expect one rate hike in December. Undoubtedly, such move will trigger some sort of volatility within bond prices. Thus investors should consider re-allocating their assets in actively managed funds which will surely adjust the portfolio’s duration to avoid any undesired downward pressure on a Fed hike. That said, if an investor requires longer duration to lock-in further returns, he must also accept a longer investment horizon and in such case long ‘modified duration’ is not an issue. For now let’s enjoy the limited upside within the fixed-income asset class.   

Disclaimer: 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. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website. 

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