The time is right for longer duration in fixed income given current expectations of higher rates, according to SYZ Asset Management chief economist and portfolio manager Adrien Pichoud.
Although at first shorter duration may appear to minimise and control risk in portfolios, Pichoud said it can in fact lead to an undue concentration of risk.
‘As investors seek to avoid duration without suffering negative returns on short-term sovereigns, they have crowded into short-term high yields and taken on more credit and liquidity risk than they would normally consider acceptable.’
At present, there is a trend of investors fearing losses from longer-dated holdings such as long-term government bonds as investors believe cash and short duration are less risky, he explained.
But this strategy forgoes a significant source of return if rates remain low for a long time.
In fact, long-term government bonds are conducive to ensuring fixed income risk management, particularly if we suffer a ‘growth accident’ similar to 2008.
‘When spreads suddenly widen and liquidity disappears, long-term sovereigns offer a cushion.’
Long-term bond holders accumulate the carry and in turn, tend to benefit from a positive yield curve slope to generate returns via the roll-down, Pichoud explained.
‘Over the last two or three years, short duration investors did not win when rates moved up; they just lost less at best. But those short duration investors also missed the best part: they failed to gain on the upside by not participating.’
Rapid rates rise
Concerns over the impact of a rapid rise in interest rates are natural, he said, but even so the potential damages are often overestimated.
‘We have looked back at US Treasury rate rise since 1977, gauging each long-term rate increase for its maximum drawdown impact and how long it took to recover from these losses. We found the duration of recovery times to be relatively self-limiting.’
Certain factors do facilitate a recovery however, Pichoud said, including reinvesting coupons at higher rates and the embedded pullback in any rates rise, particularly for economies with high indebtedness levels.
‘The combined coupon and pullback effects result in portfolios recouping all of their initial drawdown in about a year at most.’
The house view at SYZ, Pichoud explained, forecasts rates to remain low and close to today’s levels, in which case flexible strategies, including duration, can deliver outperformance by using a relative value approach.
As it stands, much of the sovereign bond world suffers from ‘Japanification’, he said, with long periods of low growth and low interest rates.
‘In such an environment, the opportunity cost of holding cash will remain very high as central banks maintain accommodating policies to support growth.’