Helping global bond investors when duration fails

BY   |  SUNDAY, 29 MAY 2022    1:59PM

Many fixed income investors have been asking about the implications of rising interest rates. While the Fed initially saw the emergence of post-coronavirus pandemic inflation as transitory, the increase in prices has been far more persistent than it had earlier hoped for. This led Fed chair Jerome Powell to say it was time to retire the term "transitory" as a description of current inflation. Even if inflation falls back to 3% to 4%, it may be a long time before it is back at the Fed's 2% target.

In the current environment, index-aware global bond investors face significant risks posed by a combination of rising market yields in 2022 and long-duration portfolio holdings. They have become increasingly concerned over their exposure to rising rates, how quickly rates will rise, and just how large the potential drawdown on a portfolio of global government bonds might be. This paper looks to address some of these key concerns, in particular what can be done to mitigate the risks from rising rates.

We believe that one possible solution is for investors to take steps to mitigate potential duration-led losses ahead of any major upward move in yields. To succeed, decisive action will be required by asset owners to ensure that their fixed income managers have the flexibility they need to manage duration risk more aggressively in an elevated inflation, rising-yield environment.

One way to acquire some insights into the potential risks is to look at scenario tests based on past periods of rising bond yields. For a scenario approach to be successful, a relatively reliable model of monthly bond returns appears essential. Fortunately, such a model is feasible, based on a three-factor approach to estimating total returns, namely the initial yield, duration, and roll-down return. Such a model is described later in the paper.

By way of historical background, looking at the top 10 government bond markets included in the Bloomberg Global Treasury Index from February 1987, the US and Japan each accounted for around 25% of the global market share, while the top 10 markets combined have a share of over 83% and, so, will clearly be the major drivers of global government yields.

In every one of these markets, the trend in government bond yields over the past 30-plus years has been lower, while the trend in duration has been higher. Nominal yields are close to historic lows, and, in some cases, yields are even negative.

This observation is very important for fixed income investors, since over medium-to longer-term horizons, the total return from government bonds tends to be close to their initial yields. This suggests that in the current environment, global bond investors should be conservative in terms of their future return expectations. The nature and importance of the initial yield-to-total return relationship is worth elaborating further.