Long haul or short stay? Duration uncovered

20 December 2017

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taipopoola

Duration misconceptions

There are several misconceptions when it comes to discussing duration. Duration does not just refer to the change in price corresponding with government bond (or treasuries) yield, nor is it just a measure of the sensitivity of a bond’s price to a move in central-bank interest-rate targets.

It is more than this. Too often it is also seen as a measure of risk and not a measure of potential to generate capital return from mispriced securities.

Link between credit spread and government bonds

Duration is a measure of the sensitivity to the change in total yield – not just one component of that yield. Yield is comprised of a ‘credit-risk free’ discount factor, typically a reference government bond yield, and some discount for credit risk or ‘spread’.

In this respect, the relationship between credit spread and treasuries matters as it determines how the overall yield, and therefore the bond price, moves.

Duration does not equate to volatility

Because credit typically has a degree of negative correlation with government bonds, duration is not a good measure of expected volatility. In terms of portfolio construction, we look at the exposure we want in terms of both credit and interest-rate risk during a given cycle, as well as any correlation between the two.

Hunting for more income by investing in ever more risky credits may actually generate more risk than taking on additional duration. More asymmetric risks in lower-quality credit means spreads widen more aggressively in negative economic environments, so even shorter-dated bonds, with lower relative durations may prove more risky as yields move higher, more quickly, than better quality, longer-dated paper.

What should investors do?

Depending on the circumstances, investors may want to have low interest-rate exposure and retain credit exposure, or they may want to make the most of any negative correlation.

If an investor has a strong view that interest rates are going to rise more quickly than credit spreads can tighten, having a duration-hedged strategy – such as Global Value Credit – could work well.

Credit selection can generate uncorrelated returns

If an investor thinks the odds are evenly balanced then a long duration strategy – such as the New Capital Wealthy Nations Bond Fund – may suit them better because the negative correlation between credit spreads and government bond yields offsets a proportion of the individual volatility. In all instances, the aim is to invest in opportunities that are mispriced and duration can be a friend not a foe.f an investor thinks the odds are evenly balanced then a long duration strategy – such as the New Capital Wealthy Nations Bond Fund – may suit them better because the negative correlation between credit spreads and government bond yields offsets a proportion of the individual volatility. In all instances, the aim is to invest in opportunities that are mispriced and duration can be a friend not a foe.

The advantage of having duration in respect of mispriced securities is that as the market rerates credit risk, spreads tighten relative to their peers. Thus longer duration securities can actually generate superior capital returns relative to the market.

Duration can be a friend from a credit perspective. Our relative value process helps us identify which under-priced bonds provide the greatest mispricing potential. Finding mispriced, long duration paper can result in some of the most attractive capital returns.

In today’s low-yield environment, this capital growth can provide a larger amount of our overall returns than in the past when yields themselves were a lot higher and carry dominated returns.