How Zero And Negative Duration Strategies Can Enhance Advisor Flexibility by Rick Harper, Head of Fixed Income & Currency, The WisdomTree Blog.
With the Federal Reserve (Fed) about to lose its patience for a zero interest rate policy and the market possibly largely unprepared for this shift, it is important for investors to develop a plan for their portfolios when interest rates inevitably rise. In our view, zero and negative duration strategies provide notable alternatives that portfolio managers should consider as a way to refine a portfolio’s sensitivity to changes in interest rates.
In previous tightening cycles, many investors have reduced their interest rate risk by:
1) increasing allocations to cash;
2) investing in shorter-maturity securities; or
3) swapping fixed rate coupon bonds for floating rate notes.
However, we find the current market environment particularly problematic, given that interest rates are starting to rise from some of the lowest levels in history. Cash currently entails a very large yield sacrifice. Short-maturity securities usually involve less yield sacrifice but are typically at maturities that are very sensitive to changes in Fed policy. Floating rate securities can offer tradeoffs somewhere between the two other options, but these will likely depend nearly exclusively on changes in short-term rates. However, the biggest issue we see with these approaches is that they all represent a dramatic shift from the traditional composition and exposure of the starting portfolio.
As an alternative, institutional portfolio managers often source the liquidity of the U.S. Treasury futures market to adjust the interest rate exposure of their portfolios. With many advisors facing operational obstacles in using Treasury futures across their accounts, exchange-traded funds (ETFs) employing zero and negative duration strategies can enable these investors to pursue similar objectives and exposures. Through our collaboration with Barclays and Bank of America Merrill Lynch, WisdomTree has packaged zero1 and negative2 duration strategies on common core fixed-income strategies that maintain exposure to traditional holdings but seek to hedge interest rate risk. In figure 1, we show the impact of blending exposures to the Barclays U.S. Aggregate Bond Index (Agg) and the Barclays Rate Hedged U.S. Aggregate Index, Zero Duration.
Figure 1: Barclays Agg: A Blended Approach to Interest Rate Risk Management
Core Bond Portfolio Blends:
For definitions of terms in the chart, visit our glossary.
As the chart shows, blending a 20% position in a zero duration strategy into a traditional long-only portfolio3 would result in a portfolio with similar characteristics but a 20% reduction in sensitivity to changes in interest rates. This comes at a cost of approximately 26 basis points (bps) per year.4 Investors can think about the zero duration and long-only strategies as a continuum. On one side, there is full interest rate risk and income potential. On the other side, zero duration, but reduced income potential due to the costs of hedging. However, since the strategy hedges its exposure via U.S. Treasury futures, the income earned on the long bond portion of the portfolio can be distributed as income. The cost of the hedge drips out of the market value of the strategy. Hypothetically, if interest rates stay static over the course of the year, the hedged strategy would underperform the unhedged strategy by the cost of the hedge. Conversely, if interest rates rise, the value of the hedge could help offset losses from the long bond portfolio. For an advisor concerned about rising rates, this blended approach could provide increased flexibility in managing risk versus reward across a portfolio.
Changes in Rates Driving Volatility and Returns
According to Barclays Research, changes in interest rates have accounted for 88% of the overall volatility of the Barclays U.S. Aggregate Index over the last ten years.5 While this volatility ultimately generated positive returns for investors as interest rates fell, what happens when rates begin to rise? To manage a portfolio’s interest rate risk, we believe that negative duration strategies can help investors navigate the upcoming shift in Fed policy. Negative duration strategies will likely have a more significant impact on overall duration, but at a higher cost from hedging via longer-maturity, higher-yielding securities. Additionally, investors may also have greater sensitivity to shifts in the shape of the yield curve, due to the mismatch between the maturity of the holdings and the hedges. In figure 2, we re-create the analysis from figure 1 but blend exposure to the Barclays Rate Hedged U.S. Aggregate Index, Negative Five Duration.
Figure 2: Blending Negative Duration into Traditional Portfolios
Core Bond Portfolio Blends: Yield to Worst vs. Duration
When viewed as a complement to an unhedged portfolio, each 20% allocation to the negative duration strategy could generate a reduction of over two years of duration, but sacrifice 40 bps in yield relative to the Agg. A 48% allocation to the negative duration strategy could bring the duration of the overall portfolio to zero and retain a net yield of 1.05% (48% of the Agg’s yield). While this portfolio has a similar duration profile to the zero duration strategy, the yield is marginally higher in order to compensate investors for the potential hedge mismatch and shifts in the yield curve.
In our view, zero and negative duration strategies offer investors a more intuitive way to manage interest rate risk in their portfolio relative to traditional approaches. Given that we may be heading into a particularly uncertain period in markets, we believe that investors should consider reducing interest rate risk in advance of any change in Fed policy. In our view, interest-rate-hedged strategies allow investors to maintain exposure to fixed income sectors they currently hold while reducing the risk of rising interest rates.
1These are: Barclays Rate Hedged U.S. Aggregate Bond Index, Zero Duration and BofA Merrill Lynch 0-5 Year U.S. High Yield Constrained, Zero Duration Index.
2These are: Barclays Rate Hedged U.S. Aggregate Bond Index, Negative Five Duration and BofA Merrill Lynch 0-5 Year U.S. High Yield Constrained, Negative Seven Duration Index.
3As proxied by the Barclays U.S. Aggregate Index.
4Source: Barclays, as of 3/13/15.
5Source: Barclays, as of 2/28/15.
Important Risks Related to this Article
There are risks associated with investing, including possible loss of principal. High-yield or “junk” bonds have lower credit ratings and involve a greater risk to principal. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. The Fund seeks to mitigate interest rate risk by taking short positions in U.S. Treasuries, but there is no guarantee this will be achieved. Derivative investments can be volatile, and these investments may be less liquid than other securities and more sensitive to the effects of varied economic conditions.
Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. The Fund may engage in “short sale” transactions of U.S. Treasuries, where losses may be exaggerated, potentially losing more money than the actual cost of the investment, and the third party to the short sale may fail to honor its contract terms, causing a loss to the Fund. While the Fund attempts to limit credit and counterparty exposure, the value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments. Investing in mortgage- and asset-backed securities involves interest rate, credit, valuation, extension and liquidity risks and the risk that payments on the underlying assets are delayed, prepaid, subordinated or defaulted on. Due to the investment strategy of certain Fund’s they may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.
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