Fixed Income – Pros & Cons Of Negative Duration

In 2011, a new category was created by Morningstar to distinguish a subset of multi-sector bond funds. The category, Nontraditional Bond, has been one of the strongest in terms of flows, with more than $55 billion in net flows last year alone. So what’s the attraction?

Exhibit 1

Source: Morningstar Direct, 2013 category flows

According to the category definition, a nontraditional bond fund differs from its multi-sector peers in two distinct ways: either the fund has an “absolute return” focus, meaning it seeks to avoid losses and produce returns uncorrelated with the overall bond market, and/or it employs an “unconstrained” approach and therefore has greater flexibility to invest tactically across sectors and manage interest rate sensitivity. This includes the ability to take a negative duration position.

At a time when Fed accommodation is winding down and the fear of rising interest rates is on everyone’s mind, these features sound fairly enticing. But what exactly does it mean to have negative duration?

Negative duration: How to get there and what it costs

To decrease duration in a portfolio, the investment manager will typically employ one or both of the following strategies: buy bonds with short(er) maturities or sell Treasury futures. The former is pretty straightforward, but the latter requires an explanation. Portfolio managers can achieve negative duration shorting Treasury futures, thereby giving the portfolio inverse exposure to Treasuries (when interest rates rise, futures contracts benefit from the decrease in prices). A fund selling enough Treasury futures would achieve a negative duration profile.

Keep in mind that selling Treasury futures is not free and can actually cost the portfolio in terms of yield and total return if the yield curve shifts down. What a portfolio manager is doing is selling Treasury futures on a specific maturity (e.g., selling the 5- or 10-year Treasury) and essentially betting that the yield on that specific maturity moves higher. The portfolio is no longer collecting that yield or rolling down the yield curve. To profit from a short position on Treasury futures, the rise in interest rates must more than compensate for the yield give-up.

Consider the example of a portfolio manager who sells 10-year Treasury futures to achieve a duration of -2 years. For this trade to make a positive total return, the 10-year Treasury yield will need to rise by at least 55 basis points — or above 3.10% — over the next year (assuming a parallel shift). This “breakeven rate” reflects the foregone yield and rolldown benefit of duration.

Selling Treasury futures is a common practice across all types of fixed income products. It’s an effective, liquid way for a portfolio manager to achieve the desired portfolio duration positioning. When used as a hedge against rising rates and rates do in fact rise, it can be a profitable trade. However, when this strategy is taken to an extreme, and negative duration is achieved, the portfolio has in effect stripped out all duration and is betting on rising rates to generate attractive returns. If interest rates fail to rise faster than what the yield curve has priced in, portfolio returns can be disappointing.

Considerations:

• A negative duration position is fighting a natural market risk premium and therefore should be viewed as a tactical opportunity only, when a buy-and-hold approach ultimately would be a losing strategy. While Treasury yields may be low, they are still positive. Bonds funds that have positive duration can still generate positive returns if yields rise gradually.

• Shortening portfolio duration for extended periods of time is not free and typically will lead to lower returns, especially if rates do not rise. (A normal yield curve illustrates that shorter maturity bonds yield less than longer maturity bonds, so going short too early and for extended periods of time is expensive.)

• Duration is one of the best performers when risk is out of favor. Think back to what worked in 2008 (see Exhibit 2). Owning zero duration means that your entire portfolio may be pointed in one direction (“risk on”) and the volatility buffer offered by more traditional bond funds has been removed.

Exhibit 2: Duration: The shock absorber of your portfolio

Source: Columbia Management Investment Advisers, LLC, 5/1/07-12/31/09. Past performance does not guarantee future results.

• Not all fed funds rate hike campaigns are bad for longer duration bonds. During the 2004–2006 cycle, long-term rates outperformed as the market experienced what is commonly referred to as a “bear flattener.” The result was short-term bonds returned 2%, while long-terms bonds returned 9.5%. In today’s environment, many are calling for a flattening yield curve and we believe there are points on the curve where owning some duration will reward investors given the steepness of the yield curve coupled with our expectations on how the yield curve will shift.

Source: Barclays, 5/31/04- 6/30/06

• Not all duration is created equally. Non-Treasury sectors of the market have yield premiums, or “spreads,” that tend to cushion certain bonds from price erosion as rates are rising. Investing in a traditional multi-sector bond fund which has the ability to diversify exposure across sectors and actively navigate interest rate volatility can offer a healthy yield and still act like a bond fund.

Conclusion

Having the ability to employ a negative duration strategy can be a useful tool to have in a fixed income manager’s toolkit. However, the key question to ask may be: Does that manager have the ability to get the timing right? At the beginning of 2014, it was broadly accepted that Treasury yields were poised to rise steadily over the course of the year. Instead, the opposite occurred. For example, 30-year Treasuries have returned more than 13% year-to-date. And fixed income strategies that have persistently had a negative duration position over the course of the year have struggled, which can be seen as a cautionary tale against fighting this natural risk premium. At a minimum, it should prompt investors to ask what should be at the core of their fixed income portfolio.