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.
Potential Tradeoffs
Although the Fund seeks to target a negative five-year duration, an increase in rates of 100 basis points does not necessarily guarantee a 5% price return. Given that interest rates may rise at different speeds along various points of the yield curve, it may be possible that the targeted negative exposure is not effective at offsetting losses from long bond positions. Additionally, should rates remain constant (or fall), the strategy may underperform a long-only portfolio. However, given the low cost of this insurance in today’s market environment, we believe that the potential upside for rising rates outweighs the potential losses in carry from putting on this exposure.
A Summary of Bond Yields and Durations as of November 30, 2013
For definitions of terms and indexes in the chart above please visit our Glossary.
As we have shown, investors have a variety of ways of attempting to mitigate the impact of rising rates on their bond portfolios. As another tool for reducing overall interest rate risk in a portfolio, strategies with a negative duration exposure can be used not only as a standalone tactical investment, but also as a way to help offset interest rate risk across their broader fixed income portfolio.
1Investors have also sought to increase credit risk in their portfolios as a way of reducing interest rate risk, but we are attempting to only focus on the impact of higher rates.