Longer-dated bonds may not sound thrilling, but they are more than capable of taking investors on a rollercoaster ride. Just take the example of Austria.
In January, 70-year bonds that the government had sold in October tumbled more than 10 per cent in price in just over two weeks, as money managers focused on signs that inflation was edging higher in the eurozone. However, in the past month the debt has bounced back 10 per cent.
While an extreme example, the swings in Austrian debt are worth remembering as investors pour back into longer-dated bonds. Emboldened by the US Federal Reserve’s signal last month that it is not primed to speed up the pace of rate rises, money managers have been extending the duration of their portfolios.
Duration, a measure of how long it takes to recoup an investment in a bond as well as its sensitivity to interest rate movements, on the $43tn Bloomberg Barclays global aggregate index shot to new record highs this month.
For passive index funds tracking the benchmark, or one of the dozens of other indices where duration is at a record, a jolt higher in interest rates would be painful.
“Duration has never been this long in my career,” says Jeffrey Gundlach, the chief executive of Los Angeles-based asset manager DoubleLine Capital. “With rates near the lowest levels ever and duration at literally the highest level ever, it is the worst possible set-up versus history. You are [taking] more risk and getting less reward.”
It is not simply the note of caution from the Fed that is sharpening portfolio managers’ appetite for duration.
After surging in November and December, the oil price has been stuck in a range this year, while the failure of Donald Trump and the Republican Congress to repeal Obamacare last month has sown doubts over whether they can deliver a package of economic stimulus powerful enough to quicken growth and lift inflation.
“The assumption was that Trump would take US growth to the next level,” says Krishna Memani, chief investment officer of OppenheimerFunds. “People have already leaned on the reflation trade and it’s rolled over. There aren’t many reflationistas left now, and certainly not in the bond market.”
Inflows to long-bond funds have resumed, with the largest two-week haul in eight months according to EPFR. Benchmark 10-year Treasury yields have fallen 25 basis points since mid-March. Yields fall as bond prices rise.
“People are thinking that maybe it [policy] won’t have as strong an effect on the economy,” adds Ashish Shah, who oversees AllianceBernstein’s $278bn fixed-income portfolio. “As we go forward, that policy aspect will be critical to how investors feel about duration.”
The growing confidence that some investors have in this view is reflected in the recent rally in US government bonds.
Longer bonds have far outperformed their shorter-dated counterparts, with sovereign bonds maturing in more than 10 years gaining 3.6 per cent over the past month, Bloomberg Barclays data shows. One- to three-year maturing notes have returned 1.3 per cent over the same period.
A major risk for such bond managers is if there were a sharp rise in global interest rates, a concern that has been tempered much of the post financial crisis period by central bank stimulus.
The longer a bond’s maturity, the bigger the risk. A simple rule is that for every percentage point increase in yields, a bond’s price will decline by a percentage of its duration. It is not just sovereigns like Austria which have been issuing long bonds. Microsoft and AT&T have both sold 40-year bonds this year.
For now, at least, the relative warming to longer bonds has been helped by hedge funds cutting their short positions, or bets on rising yields. The net short in 10-year Treasury futures held by leveraged funds, a proxy for hedge funds, has collapsed by nearly two-thirds from a high reached last month.
Those managing pension funds, as well as insurance companies, remain large buyers of long bonds, as they seek assets to meet their need to make future payouts to retirees.
“There are just a lot of buyers of long bonds,” says Nancy Prior, the head of fixed income at Fidelity. “We think rates will go up, but there are natural governors of the long end.”
Meanwhile, other fund managers have turned to long-bonds for the ballast they offer a portfolio.
Mr Shah of AllianceBernstein notes that bonds with higher durations, including 30- and 50-year sovereign paper, tend to be negatively correlated with other risk assets like equities and junk bonds. So should those asset classes suffer losses, long-bonds should rally.
“We’re overweight long duration as a hedge,” says Lori Heinel, the deputy chief investment officer of State Street Global Advisors. “We want some protection if there’s a sell-off.”
However, the Fed, firming inflationary pressures in the US and Mr Trump delivering a substantial stimulus package could yet conspire to inflict losses of their own on those pushing out duration.
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