Amy Xie Patrick: The case for active duration

After a volatile five years for fixed-rate bonds, an active approach to duration can help investors manage downside risk while capturing opportunities as interest-rate conditions change. Pendal’s AMY XIE PATRICK explains

• Active duration manages risk across rate cycles
• Flexible positioning captures opportunities as yields shift
• Find out about Pendal Monthly Income Plus fund

What we mean by duration

IT IS hard to talk about fixed income and bonds without involving the term “duration”. So let’s make it clear from the start.

The term is largely used to refer to interest rate duration – or the amount of interest rate exposure, be it in a security or a portfolio.

The concept of duration can be thought of as a multiplier that translates yield moves into price returns. For example, a portfolio with one year of duration will suffer a negative 1% capital move if yields rise by 1%. Whereas a portfolio with five years of duration will suffer a negative 5% capital move from that same 1% rise in yields.

The exact return numbers may vary, depending on the contents of these portfolios and other certain technicalities. Nevertheless, thinking about duration as the multiplier from yields to returns is a helpful place to start.

Why have duration at all?

If you’ve looked at fixed-rate bond returns over the last five years and wondered what the point of duration is – that’s a fair question.

We illustrate this in Figure 1 with the total return index of the AusBond Composite Benchmark, as this is the fixed-rate benchmark of choice for many Australian portfolios.

Over the entire five-year period depicted in the chart, the benchmark has returned only a little over 1%. Its largest drawdown was over 13.5%, from which it took more than three years to recover. Since then, volatility has continued to plague this benchmark.

The disappointment is understandable when compared with the prior 10-year period of returns, as illustrated in Figure 2.

In the 10 years following the global financial crisis (GFC), central banks mostly had trouble fighting inflation that was too low while global growth slowly recovered. Perfect conditions for a smooth and upward path of bond returns. If investors bond return expectations were set in this period, then the last five years most certainly have been a disappointment.

Understanding what drives fixed-rate bonds

Bond yields ultimately move according to economic fundamentals. That is, moves and expected moves in inflation, employment and economic growth. At their core, yields are just what the market expects policy rates or cash rates will be in the future, and since the central banks setting those cash rates are trying to navigate their economies to their target levels of inflation, full employment and economic growth, bond yields do not often become dislocated from economic fundamentals, at least not for long periods of time.

So by taking on fixed-rate bonds (or duration) in your portfolio, you are expressing a view on the trajectory of economic fundamentals. As shown above in Figure 2, when those fundamentals are moving in the same direction and supportive of stable or lower interest rates, fixed rate bonds can do really well, providing a source of income and capital return to portfolios without much volatility. The perfect description of how defensive assets should behave.

However, Figure 1 shows a backdrop of very different economic fundamentals, ridden with over-heating economies, supply-shocks, labour shortages, all against a backdrop of a higher and more uncertain climate for inflation. This is not a straightforward and supportive backdrop for bonds. At times, rampant rate hikes have brought recession fears to the fore. More recently, inflation trends have been fluctuating, sometimes giving hope to quieter times ahead, only to be interrupted by tariffs, wars and Middle East oil shocks.

Bonds, or duration, as it turns out, are not able to provide defensiveness to portfolios structurally. But doing away with them entirely would mean losing a defensive lever for portfolios should the economic backdrop start to sour.

An active duration approach

Instead of an all-or-nothing approach, the Monthly Income Plus Fund takes an entirely active approach to duration. As the periods illustrated in Figures 1 and 2 have shown, duration isn’t always helpful, and at times it can be very harmful if stability and drawdown control are what portfolios are seeking.

At a high level, an active duration approach should use duration according to where we are in the interest rate cycle. For example, someone with a mortgage should choose to fix their borrowing rate while it’s low but then switch to floating when rates are high and likely to fall. Duration within a portfolio is the same, but just flipping in the opposite direction, since we’re earning the interest, not paying it.

But it gets more nuanced than simply choosing to have a floating-rate portfolio when the RBA is hiking the cash rate, and a fixed-rate portfolio when they are easing. Markets have a way of moving ahead of central banks to price in what may be coming. Sometimes, the market consensus can be wrong about the extent to which the central bank will hike or ease interest rates, leaving room for active and contrarian views to profit within the cycle.

As Figure 3 shows, over the last five years, the RBA has engaged in one large hiking cycle, one mild easing cycle, and started another hiking cycle towards the end of last year. Yet Australian 10-year government bond yields have gone through far more ups and downs than that.

Within Figure 3, all red arrows point to occasions where the market either under- or over-shot what the RBA would eventually end up doing.

It will often be shifting fundamentals within a rate cycle that cause bouts of volatility in bond yields. By adopting an active stance on duration which looks to the signals in these shifting fundamentals, these bouts of volatility can be avoided when yields are rising (and having duration would be harmful) but embraced when yields are falling.

A strong approach to active duration ought to navigate the broader interest rate cycle well, particularly adding duration before an easing cycle begins which locks in a higher level of income for portfolios as interest rates fall. A purely floating rate credit portfolio will see its income levels fall alongside the fall in cash rates. In addition, within cycles, a successful active duration lever within an income portfolio will be able to put bouts of bond volatility to use to create added sources of return.

Where does that leave us today?

The current environment is a case in point. The US Federal Reserve’s decision to hike rates in September caught markets off guard, only to be reinforced by stronger US economic data since then. Yields have continued to climb because none of the economic fundamentals (inflation, employment and growth) are currently supportive for bonds.

For the Monthly Income Plus Fund, our active duration process prioritises leading signals about these economic fundamentals. Long before the market realised that a Fed hike was probable, we had positioned the fund for exactly that outcome. Since then, the portfolio remains fully floating-rate, earning a high level of income on offer from currently higher policy rates. There is no need for any duration in this environment, but we continue to monitor for signals of economic change. As has often been the case over the last five years of inflation and economic uncertainty, the portfolio stands ready to use its ability to take on up to five years of interest rate duration to capture the more meaningful turns in the cycle and deliver a defensive outcome for our investors.

The goal shooter

As a mother to three tall daughters, I am deep in the Saturday morning netball years, so please indulge me as I end with this sporting analogy.

Your midcourt players are in every passage of play. Centre, Wing Attack – they work to keep the ball and move it down the court. I liken this to floating-rate credit in a portfolio. Always working and contributing.

However, you need a Goal Shooter to put points on the board. She doesn’t get involved in every phase of play. Some games, she will spend long stretches waiting for the ball to come to her end of the court. But when conditions are right and the team gets the ball to her, it’s up to her to convert. That’s the job of duration in a portfolio.

A portfolio without duration is a team that has left its Goal Shooter on the bench because the ball has been in midcourt all quarter. With yields where they are today, the ball is getting closer to her circle.