Schroders: Bond investing in a rising rate environment

Intentionally or otherwise, Ben Bernanke chose a memorable date to announce the massive quantitative easing scheme - known as ‘QE infinity’ - that would change the face of markets. On the twelfth day of the twelfth month of 2012, the then chairman of the Federal Reserve (Fed) informed global markets that by increasing the Fed’s level of asset purchases to $85 billion-a-month, more than a trillion dollars a year would be injected into the US economy.

In addition to this staggering volume of stimulus, Bernanke announced that the interest rate at which banks lend money to each other (the Fed funds rate) would stay in an  ‘exceptionally low range’  for at least as long as unemployment was above 6.5% and longer-term inflation expectations were ‘well anchored’.

Throughout 2013 and continuing into 2014, assurances from the Fed and other central banks that low base rates would remain in place, combined with high levels of liquidity, have meant that yield-hungry investors have sought returns wherever they can. As a consequence, bond valuations now look stretched in a number of areas of the market.

However, the global economy now has far fewer headwinds to contend with than in 2012. US unemployment is below Bernanke’s 6.5% threshold, inflationary pressures are building, and all of this is happening while the quantitative easing programme outlined above is being withdrawn. The Fed is no longer relying on any one economic measure for rates decisions, but a hike is certainly getting closer. Rising interest rates are generally bad news for bond holders, so – with a potential rate hike on the horizon – how can bond investors insulate themselves from the risk of a correction?

One way bond investors can reduce this risk - or even prosper from a rate rise - is via unconstrained bond funds, and their active management of portfolio ‘duration’.  Duration is a measure of a bond investments sensitivity to changes in interest rates.

Duration is the way bond fund managers quantify their portfolio exposure to interest rates. The duration level, measured in years, helps determine how much of the fund’s value is exposed to a rise or fall in interest rates. Prevailing logic, when rates are set to rise, is to avoid holding too much of it, as higher rates are bad for bond valuations. The more duration you hold when rates are rising, the more money you lose.

In a conventional bond fund, the manager’s primary goal is to outperform the benchmark index and performance is generally measured relative to the benchmark’s movements. The manager’s skill is in choosing whether or not to hold the underlying bonds that comprise that benchmark index. Broadly speaking, the manager will be limited in expressing a view beyond this. Fundamentally, although a conventional bond manager can hold less duration than the benchmark, he or she cannot eradicate this duration risk altogether.

For an unconstrained bond fund this is not the case. The fund may use a broad index, in order to monitor the fluctuations in a portfolio or performance, but equally it may use none at all. In either case, the aim is to generate a total return by investing in the manager’s best ideas, irrespective of an underlying benchmark. The wider array of investment strategies available allows an unconstrained manager to allocate - or mitigate - risk in a far more tailored way. Most importantly, an unconstrained fund can also alter ‘duration’ positioning to a greater extent than a conventional bond fund.

Without a benchmark, an unconstrained bond fund has the ability not just to hold less duration than an index - as with conventional funds - but can be ‘short’ duration in specific areas. This is where investors not only insulate themselves from a rate hike, but can profit from it.  An unconstrained bond manager can sell exposure to interest rates, to profit from a fall in bond prices when rates are increased.

The most valuable tool the unconstrained bond fund has is flexibility. This ability to constantly and actively adjust the portfolio’s interest rate exposure, amongst many other measures of active risk, is what allows unconstrained bond funds to generate consistent total returns. It is the capacity for unconstrained funds to allocate duration in a targeted and active way that makes these vehicles even more valuable in a rising interest rate environment.