Post: Fund duration: time to furl the mainsail?

Fund duration: time to furl the mainsail?

We've just had a bloodbath in the UK gilt market. Over the space of three months gilt yields tripled. When the yield goes up the price of the bonds goes down so you would have lost money on the gilts in your portfolio. We think that yield rise is going to continue. We also think you should protect yourself by reducing the duration of your bonds. To see what we mean by duration and to see how to check the duration of your portfolio read on...

When sailors saw there was a storm at sea they had to furl the sails otherwise in a storm the sail could be blown away. The storm that we're seeing in markets at the moment is in the bond market. The equivalent of reducing sail is cutting the duration of your portfolio to diminish the impact of rising rates. There has been a huge selloff in UK government bonds, in fact this was so significant that the Bank of England is tweeting about it!

This is a recent article published by the Bank of England. They compare the dramatic sell-off in UK bonds with previous episodes such as the US bond massacre of 94 tantrum of 2013 or the bund tantrum in Germany in 2015. All seem to follow a very similar trajectory in the sell-off they point out in their article even though the sell-off is very severe the interest rate bonds at the moment is still very low.

This is a snapshot of the UK yield curve today. The government can borrow for different lengths of time from 1 month to 30 years and this shows the interest rate it would pay for each term of borrowing. It's less than half a percent for short-term borrowing and around two percent for 30-year borrowing. Now the drivers at the two ends of the curve are quite different. The Bank of England's Monetary Policy Committee drives the short end of the curve and that strongly affects the curve around one month. If they want to stimulate the economy the MPC will lower that rate and if they want to slow down the economy they raise the rate and indirectly this is affects inflation. The long end of the curve is quite different. It's pushed up by inflation economic growth and it's pushed down by fear and economic recession or by Quantitative Easing which is when the Bank of England buys government bonds. At the moment we don't see much fear at all there's very little sign of a recession growth has been ok but we do have QE from the Bank of England. Growth on the other hand has been fairly good and that's pushing the curve up and so's inflation which has spiked very sharply recently and it's still rising. So this is a snapshot let's look at the history of the curve for 5 year, 10 year and 20 year borrowing.

What's remarkable is that the rates have been falling for at least the last 20 years which has been great for bond investors because as the yield falls the price of your bonds goes up. What's interesting is that there seems to be a notch. The question is whether this is a turning point? Are we now going to see yields start to rise steadily for a long period of time?

Well let's see what the US Federal Reserve is doing. This is their policy rate since 2008. You can see after the Global Financial Crisis it's been zero and only in December last year did they start to raise rates.

Each of the FOMC members contributes one dot giving their best guess of the policy rate, and that's how we come up with this dot plot above. You can see they expect a fairly rapid rise in interest rates over the next two years but why should we care? We've got our own central bank and our own economy!

Well this is why we should care because there seems to be a very strong linkage between our economies. Policy is data-dependent. When growth is strong in the US that often spills over into the rest of the World and that affects bank policy but also the yield curve. We have the Fed at the top in the middle and the rate in Europe at the bottom.

The success of this guy's policies will be extremely important and yes they will affect us in the UK! Trump's come up with a private sector funding plan to fuel a 1 trillion dollar infrastructure program over the coming decade.

And so have the Democrats. They've got their own 1 infrastructure plan where they hope to create 15 million jobs over the next decade. If we do compare economic growth in the US Germany you can see how the growth is linked between the three economies. The linkage isn't perfect but we believe that if the US manages to stimulate their growth some of it at least will spill over into the UK and Germany.

The recipe of full employment which is what they currently have in the US plus government spending plus strong job creation creates a combination of growth and inflation. If you remember the drivers of the long end of the curve inflation and growth both push up yields so if we get some growth spillover from the US combined with the inflation we're seeing that could push up yields further at the long end of the curve in the UK and if we do see growth and inflation in the UK then the MPC will probably push up the short end of the curve as well.

So here's the cool bit! This is duration. I've shown here two bonds. The one on the left has a lifetime of two years. You lend a hundred two interest payments of three percent per year the right we have the same thing but for three years. Three percent interest for three years and then you get your money back. But let's say that interest rates suddenly jump up by 1%. Our bonds have frozen in an interest rate of 3 percent everybody else is getting four percent we're losing out on one percent per year for two years. If we'd lent a hundred then we'd lose 2 percent of that 98 pounds. How about the three-year bond? Well there we'd be missing out on one percent for three years so the price of that bond would go down more. It would go down to 97 pounds so you can see that the longer you lock in your fixed interest rate the greater your interest rate risk and that's why the duration of the bond is critical. A bond with a longer lifetime has greater interest rate risk because it's locking in the interest rate for a longer period of time this duration concept isn't just for single bonds portfolios or even extremely large bond funds.

Here are two of those funds by Blackrock. Both of them buy UK government bonds one key characteristic which is very different that's the duration of the fund. You can see that the fund on the left has a duration of 10.77 years - it has a very long duration. So one percent increase in interest rates would push down the value of the fund by ten percent. The one on the right has very short duration just two-and-a-half years so one percent increase in interest rates would only drop the price of the fund by 2.5 percent. So if you think interest rates are rising you prefer the fund on the right because it has a shorter duration. Conversely if you think rates are falling you'd choose the fund on the left because you want as much exposure to that interest rate fall as possible.

So if think rates are rising then now would be the time to reduce duration and to furl your sales!

Here's the legal bit... this is not a recommendation. If you want financial advice tailored to your specific circumstances seek independent financial advice.

Do you agree with us that it's time to cut duration? We'd love to hear your feedback! Tweet us @PensionCraft or message us on Facebook subscribe to our Channel