Exploring the role of duration management in credit portfolios

As any bond investor will tell you, corporate bonds are made up of three components:

• Credit risk (in the form of credit spreads) – the premium that investors demand as compensation for the additional credit risk associated with investing in corporates
• Interest rate risk – the exposure to fluctuations in government bond yields
• Liquidity risk – the ability to buy, or sell, corporate bonds versus government bonds

It is widely believed that active credit managers focus, first and foremost, on managing credit risk and that the interest rate risk (or duration) is managed to match the benchmark index of their portfolios.

However, paying insufficient attention to managing duration since the pandemic-low of April 2020 in US 10-year bond yields (see the first chart below) would have meant missing out on potential trading opportunities in government bond markets during the subsequent period of heightened volatility.

In summary, if an active manager had chosen to make their portfolio less sensitive to interest rate risk, they would have typically registered outperformance versus their benchmark during this period. By contrast, the reverse is likely to have happened if portfolio duration had been longer than the benchmark as yields rose.

Interest rates: an important driver of total returns

The second chart shows how changes in the level of interest rates can be a key driver of returns for corporate bond portfolios. For investment grade corporate bond markets in 2023, around half the total returns can be explained solely by changes in interest rates.

Available tools

So, what sort of interest rate management tools can be employed in credit portfolios?

• Active managers can manage their portfolio’s sensitivity to interest rate risk. This sensitivity, known as duration, is expressed in years. So, versus a benchmark, a manager may overweight (long duration) or underweight (short duration) this interest rate sensitivity. For example, moving one-year overweight duration (holding longer-dated bonds than the benchmark) would mean that for every 1% fall in interest rates, the portfolio could outperform its benchmark by about 1%. If a manager expects rates to rise, underweight positions can also be expressed, by holding shorter maturity bonds than the benchmark.
• Active managers can also manage curve positioning, whereby portfolios can be positioned on a particular point of the curve. As a bond portfolio holds a range of different maturities, the manager can plot the bond yields versus maturity dates and create an interest rate, or yield curve. This curve risk can also be actively managed. For example, a manager may believe 30-year bonds will underperform 10-year bonds and move overweight 10 years and underweight 30 years. This is known as a ‘steepening’ trade as if the manager is right, and 30-year bond yields rise more than 10-year bonds, the shape of the yield curve will indeed steepen.
• They can also hold bonds across countries or currencies to manage interest rate duration risk, where portfolio managers can buy from bonds in a country and sell bonds against another should they expect the differential between the two to narrow. For example, this could mean taking a view of where UK 10-year gilt yields might move in relation to US 10-year treasury yields.

At the time of writing, we believe the US Federal Reserve, the European Central Bank and the Bank of England are near the end of the hiking cycle, and the tone has shifted towards a dovish bias, with multiple basis points of rate cuts already being priced in for 2024. While the timing of the first cut is uncertain, and hotly debated amongst economists, including ours, one thing we can be certain of is that the transition from rate hikes to rate cuts will be accompanied by a high degree of increased volatility.

Although using dynamic interest rate risk management in credit portfolios is not a replacement for the more traditional skills of sector and security ‘bottom-up’ selection, we believe, that portfolio managers, such as ourselves, who seek to harness additional alpha drivers via a dedicated and specialised Rates and Inflation team, have the opportunity to achieve better performance over time.”