Don’t give up on duration

With this in mind, many investors looking at fixed income are upping their credit risk for additional yield, while shortening duration for safety. However, Charles McKenzie, CIO Fixed Income, Fidelity International, discusses why he believes investors shouldn’t give up on duration.

Charles comments: “A lot of investors, when looking at fixed income want an optimal combination of yield and safety. Often, they believe the best position to take is overweight credit risk, that generates a good level of income, while shortening duration to reduce the sensitivity to changes in government bond yields.

“That is not always necessarily the right thing to do. Shortening duration in clients’ and investors’ portfolios has two very important consequences. First of all, if duration is significantly shortened – i.e. by either hedging or favouring more short-dated bonds – you are giving up a lot of income as longer dated bonds usually have a higher yield than short-dated alternatives.

“The second important point to make is that shorter-duration leads to increasingly higher, more positive correlation between the fixed income and equities components of an investor’s portfolio. As bonds are typically held to act as a good diversifier from the equity markets, you can therefore miss out on the diversification benefit if you reduce duration by too much."

Instead, Charles outlines three ways of looking after and managing your duration.

• 1. Think global: “It is important to think globally; don’t just rely on your home market. There are different cycles around the world – investors can take advantage of being invested in different regional markets rather than just their home market. At the moment, for example, we find good investment opportunities in the US and Australian interest rate markets, where global as well as idiosyncratic factors favour a long duration exposure.”

• 2. Look beyond government bonds: “Fidelity’s research team continuously looks for opportunities across the entire fixed income universe, and in particular whether investors are adequately compensated for the additional risk of investing in corporate rather than government bonds. Opportunities exist, but careful selection is key.

“Our research suggests that currently investors get adequately compensated in terms of extra spread for the credit and default risk they are taking on by investing in corporate bonds. In particular investment grade bonds represent the sweet spot at the moment.

“The picture is more mixed for high yield bonds, rated from BB down to CCC. After last year’s excellent performance, valuations for the asset class are arguably less attractive than they were 12 months ago. Nevertheless, we still find value in BB-rated bonds, where we believe there is still appropriate compensation for the additional credit risk that investors have to face. Careful security selection remains crucial, however.”

• 3. Consider inflation linked bonds: “Inflation linked bonds are not often talked about, but being involved in real assets and inflation linked markets can also be a good diversifier for investors in fixed income. While inflation still looks very well controlled, and we expect that to continue for some time, inflation-linked bonds offer some protection if inflation does indeed surprise to the upside.”

McKenzie concludes: “With interest rates set to stay low, the right balance between yield and safety is difficult. But don’t give up on duration; it still has a very important part to play in a balanced portfolio.”