In 2013, fixed income investors were confronted with negative returns in their core bond positions for the first time since 1999. With the prospect that rates may continue to drift higher in 2014, many market participants are looking for ways to reduce interest rate risk in their portfolios.
Principally, investors have sought to reduce their interest rate risk in the following ways1:
1. Increase portfolio cash positions
2. Increase allocations to shorter maturity securities
3. Purchase floating rate securities
However, the more traditional strategies listed above often compel investors to change the overall makeup of their portfolio in addition to reducing interest rate risk. Historically, institutional investors have sought to incorporate futures positions into their portfolios in order to hedge their exposure to higher interest rates in addition to the traditional approaches above. In our view, incorporating this institutional approach not only maintains the breadth of current exposures, but attempts to address the threat of higher interest rates head on. While the three traditional, defensive strategies may help to dampen the blow of rising rates, another potential way of attempting to navigate a rising rate environment is through investing in cash bonds, but then adding a short component to the portfolio to target a negative duration exposure. As we will show, this interesting, but intuitive way of mitigating interest rate risk may prove to be a valuable tool available for investors in managing the overall interest rate risk in their portfolios.
Negative Duration Explained
In traditional bond portfolios, interest rate risk is most often measured by a bond’s sensitivity to interest rates, also referred to as duration. Assuming a 100 basis point upward shift in interest rates, the price of a 5-year duration bond is estimated to change by approximately 5%. In the case of a negative duration portfolio, this relationship is inverted whereby the short positions in Treasury Futures contracts would appreciate by 5% in the above scenario.
Negative Duration in Investor Portfolios
So how is a negative duration portfolio constructed and how do investors incorporate it into their portfolio? The WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (AGND) essentially combines a long position in cash bonds included in the Barclays U.S. Aggregate Bond Index and goes short Treasury Futures and / or bonds to target the negative interest rate exposure. Investors can use the portfolio as a standalone tool for combatting rising interest rates or be combined with other interest rate sensitive assets to target their desired level of risk.