Duration is a key measure of the risk of a fixed income portfolio. Over the last four decades as interest rates trended lower, investors were rewarded with higher returns for owning longer duration securities. Over the last 18 months, rising interest rates highlighted the risk in fixed income securities, most notably longer duration securities.
The Financial Pipeline spoke with Brian Carney, a portfolio manager with Canso Investment Counsel Ltd., about why duration is important and how fixed income managers are managing duration in order to continue to generate strong returns in uncertain times.
Financial Pipeline: Why does duration matter, especially during times of rising rates?
Brian Carney: Duration measures the interest rate sensitivity of a bond. The longer the duration the more sensitive a security’s price is to changes in interest rates. For example, the price of a 2-year Government of Canada bond with a duration of 1.9 years will change around 1.9% for each 1.0% move in its yield. In comparison, a 30-year Government of Canada bond with a duration of 20.5 years will change 20.5% in price for the same move. For the last several decades interest rates have fallen so investors have benefitted the most from owning longer duration securities. As central banks raise interest rates, fixed income markets are experiencing substantial losses with longer duration portfolios experiencing the most pain.
FP: How does a portfolio manager/team decide whether to go long or short duration?
BC: It really depends on the portfolio manager. Some managers make “top down” calls on sectors, credit quality, and duration based on their macro views, including their expectations for economic growth and inflation. Canso is a bottom-up, fundamental shop. We analyze individual companies and issues, not aggregate markets or trends, and pick companies and securities based on the risks and potential rewards of those securities. Duration in our unconstrained mandates is the aggregate result of these individual decisions. In those mandates, we do not set a specific duration target. For many of our institutional mandates our clients dictate a range around the benchmark index duration.
FP: Do managers form an opinion on central bankers and their ability to manage the situation? Or is every Bank of Canada governor or Fed chair viewed the same way?
BC: Managers form opinions on the effectiveness of central bank policy as it relates to executing their mandate – controlling inflation and creating the conditions for full employment. Over the past 12 months as inflation in Canada, the United States, and other countries moved well above the 2% target, the credibility of central bankers has been called into question.
FP: Have you changed your duration management approach or policies as the Canadian benchmark index duration keeps getting longer?
BC: No. In duration constrained mandates we manage within the constraints dictated by our clients. In our unconstrained Corporate Value mandate, portfolio duration is the result of a series of individual security selection decisions. That said, it should be no surprise that those decisions have resulted in security selection aggregating to a portfolio duration of just over two years. We just don’t believe investors are compensated for the risk of owning long duration credit priced off of long duration government bonds.
FP: If you were to assess duration risk relative to historical norms, where would we be on a scale of 1 to 10 – 10 being the riskiest you’ve ever experienced.
BC: I’d say we are at a seven and only because we’ve seen such a dramatic upward move in yields over the last 15 months already. As an example, 30-year Government of Canada bonds yield 3.0% today, versus 1.2% at the start of 2021.
To learn more about duration and how it’s affecting the bond market check out www.financialpipeline.com
Read more of Brian Carney’s thoughts on the bond markets in Canso’s April 2022 Corporate Bond Newsletter.
The views and information expressed in this publication are for informational purposes only. Information in this publication is not intended to constitute legal, tax, securities or investment advice and is made available on an “as is” basis. Information in this presentation is subject to change without notice and Canso Investment Counsel Ltd. does not assume any duty to update any information herein. Certain information in this publication has been derived or obtained from sources believed to be trustworthy and/or reliable. Canso Investment Counsel Ltd. does not assume responsibility for the accuracy, currency, reliability or correctness of any such information.