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For today’s soundbites, we speak about active duration management with Terry Moore, vice president of T. Rowe Price Group and portfolio specialist in the company’s fixed income division. We talked about the limits of passive investing, global opportunities, and we started by asking why duration is such an important consideration.

Terry Moore (TM): Duration can sometimes have a greater impact on returns than credit in periods like today where fundamentals are strong, balance sheets are in good shape for both the business and consumer, and there are no imminent risks for recession or default in the near future. In these environments, credit can perform steadily while larger macro forces can move interest rates around.

The limitations of index investing and passive investing.

TM: The most popular bond benchmarks like the FTSE [Financial Times Stock Exchange] Canada Universe Bond and the Bloomberg Global Aggregate Bond Index, they’re going to capture all of the issuance of bonds according to certain benchmark rules. The downside to index investing is that one can never buy all of the bonds that are issued. It’s just not practical. But also, if you think about the issuers issuing the most debt, they’re going to be the largest issuers in those indices. And they may not be the issuers you want to invest in. Active management allows the investor to avoid certain issuers that may be overvalued, or those with credit issues which may be risky. Passive investors do not have that luxury. Further, as active investors, we can buy bonds which sit outside the index. And there are plenty of these. So, you have a broader opportunity set and the ability to dial up and down the risk levels of the portfolio, depending on what you expect to happen in the future.

Strategies for actively managing duration risk.

TM: Well, we actually recently published two papers recommending five ways for investors to manage their interest-rate risk. One is something called structural curve positioning. This simply means implementing what we call a curve steepener, which will benefit if longer-term interest rates rise faster than shorter-term rates. The investor can short those long bonds and as the economy normalizes, growth inflation should improve, and that will push the longer-term interest rates higher, and you would benefit from that. The second way is allocating across regions and sectors. Now most investors have a natural home bias. But there’s several places around the world that can offer quality and yield and have less correlation to what Canadian interest rates are doing. The third way is to hold Euro-denominated credit and if you think about the demographics and other structural issues of Europe, the European Central Bank will likely hold interest rates lower for longer than most global central banks. The fourth way is simply — and it’s rather obvious — just buying shorter-duration bonds, right? Shorter-duration bonds will have less interest-rate risk. However, the challenge with that is that it usually means less yield. The solution to that is to combine the shorter-duration bonds with a derivative overlay called a CDX. Basically, that allows the investor to gain exposure to the spread advantage of the credit market, but without the interest-rate risk. The fifth way is just simply the active management of the total duration and that’s either through the bond selection or through liquid interest rate hedges to target specific parts of the yield curve. Those can be interest rate futures, interest rate swaps, these are very liquid instruments that are traded around the world. Now one has to be cognizant that it’s not practical to keep a significantly short-duration position indefinitely. Thus, it really does pay to be an active manager of duration risk.

Where does he see opportunities?

TM: We’re investing around the world, trying to find places that have less correlation to the Canadian bond market. We’re currently underweight developed markets like Japan, Europe, the U.K., and the U.S. where interest rates have remained lower, but where we expect them to increase over the next several months. And we’re overweight countries like Australia, Malaysia, and Chile. We’re starting to see some attractive opportunities in other government bond markets around the world that have moved ahead of Canada and the U.S.

And finally, what’s the bottom line?

TM: As bond investors, we’ve enjoyed a 40-year rally as interest rates have steadily declined to historic lows. Now we’ve likely reached the bottom. And as economies reopen, interest rates are going to likely head higher from here. That could mean capital losses for some investors, particularly passive investors. But by actively managing duration and investing in higher yielding opportunities from around the world, one may be able to mitigate that headwind and actually deliver positive total returns.

Well, those are today’s Soundbites, brought to you by Investment Executive, and powered by Canada Life. Our thanks again to Terry Moore of T. Rowe Price Group.

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