This article first appeared in Yield matters on 08 November 2016
There has been a great deal of media discussion about what happens to bonds when the Federal Reserve raises interest rates again. The broad consensus is that they’ll raise, so the questions become: by how much, how often, when, and what’s the RBA’s likely response?
Most commentary has focused on ‘fixed income’ as a class, rather than individual bonds versus funds. Analysts and the media have not differentiated between holding individual bonds vs index tracking or benchmarked bond funds or ETFs.
Most of the questions concern the effect of duration on performance. Yet the answers for a bond fund / ETF vs an individual bond are fundamentally different even though they’re in the same asset class. Our analysis demonstrates the significant difference duration will have on owning individual bonds versus perpetual funds or ETFs.
We examine interest rate risk: the unexplained risk of bond index funds.
A word on duration
Duration is an estimate of the sensitivity of bond prices to incremental changes in interest rates.¹ This measure is also referred to as modified duration.
In the example below we look at three theoretical government bonds each with 3% YTM (yield to maturity), a 3% coupon, but different maturities. The price of all three bonds is 100.00% or par.
|A – 1 YEAR||3.00%||3.00%||100.00%|
|B – 3 YEAR||3.00%||3.00%||100.00%|
|C – 30 YEAR||3.00%||3.00%||100.00%|
Now assume interest rates go up by just 0.01% and the bonds now all have YTMs of 3.01%. So how does the price of each bond behave? In the table below a new price for each bond is calculated using the RBA bond pricing formula.
|BOND||NEW YTM||NEW PRICE||CHANGE IN PRICE||MODIFIED DURATION|
- 1 year bond price falls by just 0.01%
- 3 year bond price falls by 0.028%
- 30 year bond price falls by 0.197%
For the 30 year bond, the small change in YTM of just 0.01% changes the price by 0.197%. Therefore, its modified duration is described as being 19.7. Its price moved 19.7 times the move in its YTM.
The higher the duration – the greater the sensitivity to interest rate moves. Stated another way: the greater the modified duration of a bond, the greater the interest rate risk of the bond.
In a recent Yield matters article, we quoted a CNBC article that coined the phrase “Perpetual Duration²”. To understand this, we need to look at how a bond index behaves and how this affects funds or ETFs that track or are benchmarked off the index.
An index describes any investable universe of securities, whether shares or bonds. So imagine a bond universe with just 2 bonds:
- Bond A = a 1 year bond
- Bond B = an 11 year bond
- Assume that the duration of each bond is the same as its maturity³
- Each bond has $50 million on issue.
- An index would then describe the universe as having a market capitalisation of $100 million and a modified duration of 6.00. Where index duration is defined as the weighted average duration of all bonds in the index, or [($50mm x 11 years) + ($50mm x 1year)] ÷ ($50mm + $50mm) = 6
Assume a year passes and no new bonds are issued. Bond A matures.
- The index is left with bond B, which is now a 10 year bond. Index duration has also become 10.
- The index is now 100% allocated to bond B and it now has a duration of 10.
In this highly simplified example, an index tracking fund would have had to use the proceeds from the maturing bond A to reinvest in the only remaining bond, the 10 year bond B.
The duration, or interest rate risk of the fund has jumped from 6 to 10.
The price impact of a 0.25% increase in rates has gone from -1.5% to -2.5%.
Question: Did fund investors know this would happen?
Answer: Probably not. They thought they were being prudent from a diversification point of view by investing in a bond index.
The same thing happens when coupons are paid by bonds in an index fund. The coupons are theoretically invested in the remaining bonds, which causes the overall duration of the fund to increase.
Chart 1 shows the clear step-movement in duration of the Bloomberg AusBond Composite Index. As old bonds mature, and new longer-dated bonds are included coupons are reinvested in the remaining bonds. This happens on a monthly basis because the index is rebalanced at the end of every month.
Chart 1 Bloomberg AusBond Composite Index – Modified Duration
How has the Composite Bond Index (the Index) evolved over time?
Chart 2 shows that the index’s duration was actually decreasing from 4.00 in the late 90s, towards 3.17 in 2007. But since 2009 the index’s duration has steadily climbed to its current level of 4.87ˆ.
The change is dominated by new issuance. After 2007 it was difficult for borrowers to fund long-term, especially corporates. Since 2009 with increasing government deficits, the Australian government, which is the largest single issuer in Australia has issued longer-dated debt.
In October 2016, the Government issued $7.6 billion of 30 year bonds maturing in 2047.
This concept of the index continually increasing in duration is what was being referred to by CNBC as perpetual duration. It is happening to debt indices globally and the CNBC article was mainly talking about the US manifestation of this issue.
Chart 2 Bloomberg AusBond Composite Index – long-term changes in modified duration
Why should an adviser or end investor be concerned with a 30 year government bond or increasing duration generally?
The size of the new government bond, its long-dated maturity and very large duration will increase the modified duration of the whole index by 0.18. This is considered one of the biggest month-end adjustments on record.ˆ
Therefore, the question has to be asked. Do passive investors in an index tracking fund, or a fund that’s benchmarked against the index, know they are just about to inherit more interest rate risk?
If you are invested in funds or ETFs, you cannot wait for maturity to receive your capital back because funds and ETFs are perpetual. You need to sell your units. But if rates have already gone up and bond prices have fallen, then the loss of capital is locked in unless rates come down again.
Bond fund and bond ETF managers do not spend a great deal of time talking about interest rate or duration risk of their funds. There is always commentary on returns on bond funds when rates are falling and duration works in their favour.
But it’s now that advisers and investors need to be aware of the risk inherent in bond funds and ETFs. Rates will rise at some stage and if the duration risk of funds and ETFs is also increasing in parallel, it’s important all advisers are aware of this. They need to make their clients aware of these risks if they are investors in managed funds or ETFs.
What about owning individual bonds or XTBs over bonds
If rates rise, individual fixed-rate bonds will also fall in value, just as funds and ETFs do. But they also mature at par, which is the critical distinction.
If an investor holds a 5 year XTB with a modified duration of 5. In one years’ time its approximate duration would be 4 (currently the average duration of all fixed-rate XTBs is 3.13). If rates do rise – you have the choice of holding to maturity to receive your capital back. And the YTM you bargained for when you bought the XTB on ASX.
Chart 3 illustrates the movement in modified duration over time of the Crown bond XTB, YTMCWN and that of the index. As the maturing XTB moves towards its maturity date, its duration falls continually.
Chart 3 Bloomberg AusBond Composite Index Modified Duration versus the Crown bond XTB
Think about the price of any investment grade bond with 3 days to maturity when $100 is being paid back. Even if rates shot up, the bond price will not react. All the bond is at that stage is a promise by that issuer to repay the $100 in three days. The interest rate risk is practically nil close to maturity.
But meanwhile the index duration is increasing all the time. As is the interest rate risk of all investors in index benchmarked or tracking funds and ETFs.
XTBs – offering choice
By selecting individual bonds, or XTBs over them investors have choice. An investor can select what duration they would like. In a falling interest rate environment an investor may choose XTBs with much longer duration (that work in your favour if rates are cut). In a rising interest rate environment an investor may wish to choose shorter-dated duration.
But perhaps the most important economic feature of owning bonds individually, is that they will mature at par, and so if rates have increased, the bond or XTB will mature at $100 anyway. Funds and ETFs will not and price decreases and loss of capital is locked in if rates keep rising.
This is not a criticism or funds or ETFs. Diversification and reducing your risk to any one bond issuer defaulting on their payment obligations (credit risk) is obviously an important consideration.
With many bonds to choose from (there are 48 XTBs on ASX), you can still achieve diversification with individual bonds. But without giving up the maturity and repayment of capital, which causes the very significant difference between holding bonds in funds/ETFs versus individually.
¹ Frank J. Fabozzi: The Handbook of Fixed Income Securities Eight 2012 McGraw Hill
² Shelly Shwartz , CNBC “Bonds vs Bond Funds”
³ The term duration is used interchangeably with Modified Duration. MD is usually less than a bond’s term to maturity.
ˆ Source Bloomberg
∧ Source Westpac
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