Look under the bonnet of bond benchmarks

The average maturity of widely-followed fixed interest indices has quietly been extending longer and longer. David Scobie, senior consultant at Mercer, takes a look at the potential implications for investor portfolios.

Wednesday, August 31st 2016, 6:00AM

The most commonly referenced international bond benchmark, the Barclays Global Aggregate Index, is poised to reach seven years - not in age (it has been around a lot longer than that) but rather in duration, being in simple terms the Index’s average weighted term to maturity.

Why should we care about such a milestone? The answer lies in how the Index’s duration has tacked over time and how that affects investment returns, particularly in the current context of historically low (in some cases negative) interest rates.

Know thy duration

Duration gives us a measure of effective bond maturity by taking account of all cashflows, being both coupons and final principal. It is important to investors as it indicates the sensitivity of bond exposure to changes in interest rates. All else being equal, bonds with higher durations have greater price volatility than bonds with lower durations. The longer the duration, the greater the price will fall for a given rise in interest rates and vice versa.

In common with many conventional fixed interest benchmarks, both globally and locally, the duration of the Barclays Index has progressively lengthened, particularly over the past decade.

Currently sitting at 6.9 years, this compares to 5.5 years in 2010 and an average of 4.9 years prior to the Global Financial Crisis (1990-2008). There are a few key drivers behind this.

As interest rates have fallen, new bonds issued into the market have had lower and lower coupon rates, while bonds with higher coupons have matured. This means that the cashflows from fixed income have become more dominated by the capital return at maturity.

There has been a tendency toward longer-dated issuance by both governments and companies so as to lock-in the alluring borrowing rates on offer. While not the focus of this article, of note is that these issuers have diminished in credit quality on average – a risk development in itself.

From the demand side, buyers have been tempted to add longer-dated assets to their portfolios in pursuit of positive yield.

The consequence of the longer duration for investors is that, by being in a fund which closely or broadly tracks the Barclays Index, the interest rate risk exposure has increased markedly over time. And it has happened without an investor necessarily having made any active decision.

A related issue is that the yield on the Barclays Index is now just under 1.2% compared to, say, 4.3% a decade ago.

Investors are receiving lower compensation per unit of interest rate risk for their investment. At the same time, the positive return “carry” from hedging to local currency has reduced in recent times, alongside the Reserve Bank being on an opposite monetary policy path to that of the US Federal Reserve. Hence the buffer to help insulate a fund’s overall return from any downward movement in the capital price of bonds has diminished.

So is this a comfortable state of affairs for investors? That depends on your outlook for the direction and volatility of global interest rates. If you believe that yields are likely to rise in the short-medium term (particularly at a relatively brisk pace), then that could have an adverse impact on future portfolio returns. Even if you hold no view you should be aware that, by default, indices have been changing the risk characteristics of your portfolio.

We need not jump to the conclusion that additional duration is a bad thing. Global economic weakness and low inflation in recent years have pulled yields downward, thereby generating solid returns for bond holders, and high quality credit exposure is typically a useful safe haven for investors during times of market stress. However, when it comes to duration, the relevant question is “how much is too much?”.

There is no sign of a tapering off in the trend to higher duration in conventional benchmarks. One might wonder where it ends, and moreover, what the rationale may be for an investor to passively follow.

Forewarned is forearmed

Most portfolios would do well to retain material exposure to the diversification and liquidity benefits of fixed interest. At the same time, some caution by way of having regard to “duration creep” in bond indices is warranted.

The dominant theme of lower-for- longer interest rates is embedded in current pricing for equities and other risk assets as well as fixed interest. Portfolio risk can be managed via asset allocation decisions, or in some cases we have worked with clients to consider alternative benchmarks or partial use of more absolute return-oriented solutions.

In summary, bond indices are dynamic beasts, with evolving risks - some of which are not as readily observable as a headline yield. Strong exposure to duration has been a tailwind to portfolio returns for an extended period but, under some macroeconomic and volatility scenarios, it could prove to be a less-than- welcome attribute.

* David Scobie is a principal in Mercer’s Investments business, based in Auckland. This article does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.

Tags: bonds