Andrew Ash – Head of Manager Research
Head of Manager Research
Fixed Income
17 Jun, 2024

Duration is back

In late 2011 the US 10-year bond yield went below 2% for the first time in the past 100 years, and for the next decade rarely got above that level, and indeed fell to around 0.50% during the COVID pandemic in 2020. For much of that decade, despite the low levels of yield, being long duration in your portfolio delivered strong real returns as bond yields moved ever lower. The long-term forward-looking returns, however, looks skinnier and skinnier, with the term premium highly unappealing given the risk that inflation would return at some point. We all now know the story of the last couple of years as inflation surged in 2021 and 2022, followed thereafter by one of the steepest and most synchronised global interest rate hiking cycles in history. Unsurprisingly this led to the largest bond bear market, since the 1970s, with bond markets down over 10% in most markets. That damage having been done, however, bonds look far more attractive as an asset class on a go forward basis. Good quality investment grade bond portfolios have a yield to maturity of around 5-6%, while central banks look to be slowly but surely bringing inflation back to their respective targets (typically 2-3%). Indeed some central banks have already started to cut rates. A positive real return on bonds can be more confidently predicted than at any time in the past 13 years. Accordingly, allocations to traditional diversified and highly quality bond strategies should have a place in your portfolio. The downside with traditional bonds are far more limited in 2024 and beyond. The maths of convexity with bonds means the higher the starting yield, the less a rise in yields hurts returns. For example, when US 10 year Bond Yields were 1% in 2020-2021, a 100bps back up in yields resulted in an approximate 5% loss. As we sit today, however, with the US 10 Year yield around 4.5%, if we had a backup in yields by a 100 bps across the curve, losses would be around 1.5%, far less than the prior environment given the high starting yield. We consider a 100 bps rise in yields to be relatively unlikely at present, given the broadly disinflationary environment, and as such the downside on bonds look relatively limited. Conversely there may very well be some meaningful upside in Bonds in the next year or so if the long-debated recession in US (and domestically) does actually occur. This doesn’t have to happen for bonds to be attractive, but it does provide a nice asymmetry to the likely return profile of bonds going forward.

What interest rate duration is my manager taking?

With interest rate duration set to reward investors again on a medium-long term basis, it’s certainly time to consider what exposure you have in your portfolio to this risk premia, and which managers are you allocating too for this. In the same way that not having enough equity beta in your portfolio can be a long-term detractor from returns, not having enough interest rate duration could also be a drag on potential returns in the defensive part of your portfolio, as well as reducing diversification. Within that however, yields at the front end of the curve are higher than the long end (US and Australia curves remain inverted at this point), and there has been a strong argument to stay shorter in your duration in the short-term, particularly as growth and inflation remain somewhat elevated. Likely the most efficient way to manage the challenges here is with an active manager that has demonstrated an ability to add alpha via duration positioning over time. With that said generating alpha via duration has not necessarily been a happy hunting ground for many active managers, with it being a highly efficient market. On our High Conviction List, however, we have identified a small handful of diversified managers whose alpha attributon through time has included interest rate duration, and we expect to deliver long term alpha going forward.

With that said, many portfolios we look at today have a heavy overweight to floating rate credit. This has proved to be an excellent source of excess returns in recent years as credit spreads have tightened to very low levels, and as these strategies have avoided the pain that benchmark duration strategies have endured since 2022. However, as highlighted above, we like the asymmetry of strategies with benchmark like duration over the medium to long term, while there is a question on how much more upside there is in credit given tight credit spreads. Furthermore, floating rate credit exposures will likely generate much lower returns in a recession as credit spreads move wider. This is not to argue for swapping out credit for duration, but rather to consider reviewing the balance and diversification you have in your portfolio across these two levers. We have a range of duration and credit options on the High Conviction List, both active and passive, that should facilitate a well-diversified Fixed interest portfolio for the current environment.

Whither the Absolute Return Bond Fund?

The last decade of ever lower yields saw an ever increasing number of unconstrained or absolute return bond funds in market. This was a response to asset allocators seeking to generate higher absolute returns from their defensive assets when interest rates were near zero. The better absolute return strategies have been meaningful contributors to portfolio returns while also reducing risk. On a relative return basis, even if some of these absolute return strategies were delivering small single digit losses in recent years, they were providing far better returns than the double digit drawdowns we saw with traditional Bonds. As we look forward, however, allocating to traditional bond strategies looks attractive as has been discussed. In this environment an allocation to an absolute return bond fund is less obvious than it once was. While there are a broad range of absolute return bond funds doing quite different things, they are broadly more reliant on manager skill to generate real returns. This is distinct from the traditional bond fund manager where the bond beta will do most of the heavy lifting. The traditional bond fund manager may underperform the market but still likely deliver a positive real return going forward. Conversely, and as we have discussed in other commentaries, the more reliant a strategy is on the actual skill of the manager to generate positive absolute returns, the more work you have to do to be certain about the actual skill of the manager, otherwise you may well be looking at an expensive way to generate a return lower than cash. On our High Conviction List we have a small, but we believe, high quality list of absolute return strategies that continue to warrant their place in a defensive allocation both from a return and diversification perspective.

Given the fundamental change in the outlook for fixed interest investing, now is an important time to review the specifics of your defensive allocations. To support this, our Fixed Income Sector Review identifies who we believe to be the best managers in market across various styles of Fixed Income investing. If you are interested in this Review document or our High Conviction List of managers more generally, please reach out to your Mason Stevens Relationship Manager for more information.

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