Fears of principal losses spur short-duration shift

Money managers investing in European fixed income are taking shorter duration bets to protect against impending capital losses in the continued low-interest-rate environment.

Sources said the conversation has moved on from generating yield, and instead is focused on mitigating the greater risk of losses to principal. With yields at record lows, indeed, some German and Dutch government bonds offer no yield at all, investors are applying flexible fixed-income strategies or allocating to cash or corporate credit to reduce volatility in the portfolio.

“Coupon protection is not existing anymore,” according to Mauro Vittorangeli, chief investment officer, conviction fixed income, at Allianz Global Investors, based in Paris.

The Allianz Flexible Bond Strategy, which Mr. Vittorangeli manages, has e1.1 billion ($1.2 billion).

Stephan Hirschbrich, head of global rates at Union Investment, based in Frankfurt, agreed that “because of the low yield level, there is no buffer for the interest rate due to (the) coupon.” Union has e50 billion in total fixed income.

The U.K. gilt index is now 12 years in duration, which means that if interest rates increase only 1% this will tally to a -12% loss in value, Mr.Vittorangeli said.

By comparison, the duration for the eurozone bond index is seven years, which means that on every increase in yield by 100 basis points, investors lose 7% on the value of the security, Mr. Hirschbrich said.

“We are in a situation where ever more risk is being taken on by investors as coupons have fallen in this low-interest-rate environment, while corporate spreads have narrowed and subsequently yields are lower,” said April LaRusse, London-based senior product specialist at Insight Investment.

“Certainly, investors now seem prepared to take on a heightened level of risk. This appetite is not necessarily unprecedented but it is fair to say that we are moving into uncharted waters.”

Managers have preferred low-duration strategies in anticipation of rates rising. But the exact opposite has happened in recent years as central banks have continued to cut rates since 2014. As a result, market expectations are higher for the central banks' next move as yield spreads have tightened.

With this kind of central bank action, government bond markets across the world have become overpriced, leaving managers struggling to produce fixed-income returns.

According to Paola Binns, London-based senior credit fund manager at Royal London Asset Management, a shorter duration strategy protects a portfolio against potential interest rate increases and corresponding capital losses on longer-dated bonds.

Ms. LaRusse added that “investors with the flexibility to look further afield might consider strategies which provide international diversification of portfolio risk, such as through a globally diversified approach to credit.”

According to Kate Hollis, senior investment consultant on the credit research team at Willis Towers Watson PLC, London, there has been some movement into lower quality or more illiquid fixed-income strategies by those investors who are able to do it.

“There have also been a few investors selling bonds denominated in low-yielding currencies and buying dollar bonds, but the benefit of this is diminished if the investor hedges the currency risk.”

In addition, in markets where asset managers are mandated to produce returns by meeting specific portfolio targets such as in Germany, the Netherlands and even Japan, the negative yield environment is making duration and credit risk more apparent.

Mr. Vittorangeli added that the “U.K. is not really far behind Europe as we are in the last phase of the bond rally”.

Central banks globally continue to distort bond prices through quantitative easing, and as things stand managers do not anticipate an increase in interest rates in the near term.

According to Mr. Hirschbrich, quantitative easing will be supportive of the European bond market, and there is no reason to think that interest rates will go up in the eurozone before the end of the year.

Sources said the European Central Bank's quantitative easing will likely continue beyond March 2017. But if the U.S. raises rates before year-end, there could be a chance for pressure in the global market, they added.

“The global demand for U.S. treasuries have been very high and it is becoming apparent that the Fed is on its way to increase interest rates,” Mr. Vittorangeli said.

Mr. Hirschbrich believes, however, that if yields for U.S. Treasuries and bunds go up that would be an opportunity to lengthen the duration.

But there is a silver lining for investors — the low-yield environment has triggered new bond issuances. The ECB seems to have achieved its goal to induce a credit cycle as companies began issuing bonds with no coupon, including Sanofi-Aventis Groupe SA and Henkel AG & Co., which sold $2.1 million and $1.3 million, respectively. n