Download Managing Rising Interest Rate Fears

Viewpoint
August 2015
Your Global Investment Authority
Managing Rising
Interest Rate Fears
With interest rates at historical lows, some investors
are looking ahead to the possibility of a rate rise.
Head of PIMCO Australia Adrian Stewart explains
how managing duration is the key to reducing risk in
a rising interest rate environment.
Interest rates in many countries reached historical lows in recent years
as central banks aggressively cut rates in the wake of the global financial
crisis. This provided a tailwind for bond investors, but all good things,
inevitably, must come to an end.
Adrian Stewart
Executive Vice President
Head of PIMCO Australia
As some economies show increasing signs of recovery, the interest rate
cycle is showing signs of potentially turning. Investors are left facing two
key questions: When exactly will interest rates rise, and how can the
impact on bond portfolios be managed? These are genuine concerns
for some investors.
We believe that a big rise in interest rates in the short term is unlikely.
The overhang of sovereign debt in the financial system – which helped
prop up economies after the financial crisis – is too large relative to GDP
to be sustained unless interest rates remain low or growth surges well
above expectations.
Nevertheless, the combination of slower yet stable growth, a low-inflation
environment and a highly levered borrower base – a market condition we
call The New Neutral – is producing a subtle rise in interest rate risk as the
duration of many bond portfolios is rising.
Bond duration is a measure of a portfolio’s sensitivity to changes in interest
rates and, as one of the drivers of investment returns, it is a crucial factor
for investors to consider. It can be both a positive (when interest rates fall,
the capital value of fixed interest securities typically rises) and a negative
(when interest rates rise, the capital value of fixed interest securities
typically declines).
The duration of the benchmark Barclays Global Aggregate Index has now
stretched out to more than 6.5 years in part because companies and
governments are able to issue longer-dated bonds in the current benign
environment. Although this trend has been less obvious on Australian
shores, the duration of the Bloomberg AusBond Index has also now been
pushed out to more than 4.5 years.
How big an impact could rising rates have on bond
portfolios? In theory, if a portfolio with a duration of six
years faced a 1 per cent rise in interest rates, the value of
the portfolio would decline by approximately 6 per cent.
In reality, such a big change in mark-to-market is unlikely
to materialize. A well-managed bond portfolio comprises
hundreds of underlying securities, each with its own
duration and attributes, such as country, sector, credit
quality and maturity, and the impact of a rate rise on
each bond in a portfolio would therefore be different.
It’s also important to remember that, even though bond
prices may decline in a rising interest rate environment,
it is not a permanent loss of capital: Bond prices tend to
drift back to par as they approach maturity, when the
original capital, or principal, is repaid.
Flexible duration
Nonetheless, rising interest rates can affect the value of
a bond portfolio. Fortunately, the risk can be managed.
One of the most effective ways is to remove the shackles
from a fund manager’s ability to handle bond duration.
A bond strategy with flexible duration can mitigate
interest-rate risk and complement an investor’s traditional
core bond holding in a rising interest rate environment.
A skilled bond manager can use a range of flexible
duration approaches which not only have the potential to
generate higher returns than a core portfolio, but also have
the advantage of maintaining the portfolio’s bond-like
volatility. A flexible duration portfolio also retains the other
traditional attributes of a bond fund – diversification, daily
liquidity, income and capital protection.
For example, if interest rates are expected to rise, then a
portfolio manager using a flexible duration approach can
shorten the duration of the portfolio by selling long-term
bonds and buying short-term bonds. It is a simple strategy
but one that requires extensive breadth in the bond market
and management skill.
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AUGUST 2015 | VIEWPOINT
In the global bond market – valued at approximately
$100 trillion, almost double the size of the global equity
market – a skilled manager can find many opportunities
for managing duration and enhancing investment returns.
If interest rates are rising in the US, for example, a portfolio
manager can lower exposure to that country to manage
the portfolio’s duration.
Similarly, varying the exposures in a portfolio to certain
bond sectors, such as mortgages, corporate bonds and
floating-rate securities, can also help protect a portfolio
against rising interest rates.
Increasing the potential for higher returns
While managing interest rate risk directly is crucial, taking
advantage of other opportunities to increase bond returns
is also important in a rising interest rate environment.
The current market presents a range of opportunities
for bond investors.
Central banks’ accommodative monetary policies are
likely to create a favourable environment for generating
additional returns via spread strategies. Promising growth
prospects in the US and strong corporate balance sheets in
several developed markets, including Australia, also make
credit-related sectors attractive.
Many investors could benefit by looking at their bond
portfolios now, while interest rates remain low, and
assessing how well they are positioned for rising interest
rate risk. A flexible duration strategy designed to mitigate
interest rate risk and improve returns can help bond investors
navigate the next stage in the interest rate cycle.
Sydney
PIMCO Australia Pty Ltd
ABN 54 084 280 508
AFS Licence 246862
Level 19, 5 Martin Place
Sydney, NSW 2000
Australia
612 9279 1771
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Data as at 30 June 2015.
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