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As we explored in our last blog post, Helping European investors navigate inflation fears, the current market environment presents challenges for fixed income investors. Chief among them: rising interest rates. Against this backdrop, rather than simply take a portfolio’s effective duration1 at face value, we encourage investors to consider a multitude of factors when deciding how best to allocate their fixed income capital. One such factor is that of empirical duration, which (as opposed to effective duration) calculates a bond’s sensitivity to rising rates based on historical data versus using a preset formula.
As global central banks take steps to tackle inflation, a variety of monetary policy responses remain possible throughout the remainder of 2022. Figure 1 highlights three hypothetical scenarios.
From a purely theoretical standpoint, the concept of duration implies that all non-floating-rate fixed income portfolios will suffer negative returns in a rising-rate environment. As yields increase, bond cash flows are discounted at a higher rate (the “discount effect”), causing bonds to fall in value. Taking effective duration at face value suggests that portfolios with positive duration will experience negative returns as rates increase, while portfolios with higher effective duration will fare worse than those with lower effective duration. But that doesn’t tell the full story.
In fact, credit risk can offset a negative discount effect from higher nominal bond yields. In an inflationary environment, rising yields are often a reaction to a strengthening economy and, therefore, related to a decrease in default-rate expectations — the “association effect,” which is generally positive for credit-heavy fixed income assets, with overall returns resulting from the offsetting discount and association effects. This relationship highlights the importance of considering the source of nominal yield increases (inflation expectations versus real yields) when allocating fixed income capital.
As noted, empirical duration calculates a bond’s duration based on historical data, with the difference between effective duration and empirical duration revealing the impact of credit risk. Generally, empirical duration demonstrates that true interest-rate sensitivity tends to fall for riskier bond sectors as the association effect offsets the discount effect.
Figure 2 shows that fixed income sectors with negative or relatively low empirical durations may actually offer some protection in a rising-rate environment. In particular, for sectors where returns are primarily driven by credit outcomes, such as high-yield bonds and emerging market debt (EMD), the strength of the credit market and of the underlying economy may be more decisive than interest-rate movements in determining sector returns. One option for investors in a rising-rate environment is to add to or prioritise sectors that exhibit negative or low empirical duration, thereby potentially improving or perhaps at least defending overall portfolio performance.
Another factor to consider is that empirical duration measures historical asset-class sensitivity to changes in local interest rates. With US and European rate hikes set to occur on different timetables and at different speeds, how European assets react to changes in US rates (assuming European rates stay unchanged) becomes a critical factor. Our analysis suggests that high-yield bonds and external EMD have also historically exhibited low or negative empirical duration when benchmarked against different yield curves (e.g., local and nonlocal; German and US), making them potentially attractive credit allocations as rates rise.
In a rising-rate environment, fixed income return outcomes will inevitably vary by sector. Performance depends on several variables, such as credit risk and the degree to which nominal-rate increases are driven by higher inflation expectations. Empirical duration offers insight into how various sectors have historically responded to changes in nominal yields and, in our view, better captures the interplay between interest-rate risk and credit risk.
While interest-rate increases should theoretically produce negative returns for any bond portfolio with duration, combining empirical duration with a positive outlook on the current credit cycle gives us reason for optimism regarding some fixed income risk assets’ prospects going forward.
1The effective duration of a bond or portfolio is essentially its price sensitivity to rising interest rates, measured against a given benchmark yield curve.