Managing your bond allocation in a rising yield environment

25 Mar 2017

In our view, investors need to review the duration of their benchmarks – especially any that were set up some years ago – and to look at what can be done, both strategically and tactically, to reduce the risk to portfolios from a rise in bond yields. With the current yield (as at 15th March 2017) of the Barclays Euro Aggregate Treasury benchmark at 0.71%, and the 10-year Bund yielding around 0.45%, the expected returns in the next few years from this benchmark will certainly be a lot lower than in the past. They could even turn negative if the European Central Bank’s (ECB) quantitative easing (QE) policy ultimately generates inflation.

Following a broader description of how bond markets have evolved in recent years, the Multi Asset Solutions* team presents a number of possibilities to help clients face the coming challenges of investing in bonds and to alert them to the risks that exist in this environment.

 

Evolution of bond markets and bond market characteristics

Over the last decade and a half, the modified duration of the Barclays Euro Aggregate Treasury benchmark rose from 4.75 years at the end of 1999 to a peak of 7.8 years on 1 August 2016, before falling to 7.3 years today (as at 15th March 2017).

One reason (but not the only one) for the rise in modified duration has been the drop in yields over this period, as can be seen in graph 2 (we use January 1999 as the start date for both graphs 1 and 2 as it coincides with the introduction of the euro). While the global financial crisis (GFC) in 2007/8 and the eurozone sovereign crisis in 2011 caused yields to rise, the modified duration kept on rising until the recent sell-off. Another reason for increasing index duration has been a change of the pattern of issuance by governments in favour of longer maturities.

The explanation for a drop in yields leading to a rise in the duration and modified duration of a benchmark is to be found in the formulae for the calculation of the duration figures in Frank J Fabozzi’s ‘Handbook of Fixed Income Securities’ (7th edition, with Steven Mann, published by McGraw Hill, 2005):

Modified duration (MD) can be written as:

Modified duration = 1/(1+Yield/k) * {( 1+PVCF1 + 2* PVCF2 + …. + nPVCFn)/k*price}

Where:

 k = number of periods, or payments, per year (e.g. k = 2 for semi-annual pay bonds)

 n = number of periods until maturity (i.e. number of years to maturity times k)

 yield = yield to maturity of the bond

 PVCFt = present value of the cash flow in period t discounted at the yield to maturity

The expression in the parentheses on the right of the modified duration formula given by the equation above is a measure formulated in 1938 by Frederick Macaulay, popularly known as the Macaulay duration.

This modified duration is commonly expressed as:

Modified duration = Macaulay duration / (1+ yield/k)

The modified duration is the percentage price change of a security for a given change in yield. The higher the modified duration of a security, the higher its risk. As the yield drops, both the duration and the modified duration increase because, as shown in the formulae, they are being divided by the yield.

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