We’re addressing interest rate sensitivity in your clients’ portfolios—talking about views on duration with a focus on helping limit risk.


 

Todd Crawley: We’re addressing interest rate sensitivity in your client’s portfolio—talking about views on duration with a focus on helping limit risk. I’m Todd Crawley, and this is The Essential Practice podcast.

He’s become kind of our go-to-guy for fixed-income-related topics. Joining us once again is Danny Sarnowski, portfolio specialist with Wells Fargo Asset Management’s Global Fixed Income Platform. Danny, welcome back.

Danny Sarnowski: Thanks for having me.

Todd: Well Danny, duration’s become a pretty hot topic here lately. In fact, it’s one of three central themes of our 2019 Investment Insights report, which will be coming out soon. In your view, why the focus on duration at this point in time?

Danny: Yeah, it’s a great question, and I think the reason is that duration is front-and-center for a lot of investors these days, because rates have been rising. Whether we’re looking at the front-end of the curve, where the Fed is controlling the Fed funds rate—they’ve raised that eight times in the last two-and-a-half years, and the expectation is that we’ll continue to see rate hikes from the Fed. But even in the intermediate and longer-term end of the curve, rates are rising. The ten-year treasury is up more than 80 basis points year-to-date. So those types of market movements can certainly have an impact on client portfolios. And when people look at building a bond portfolio, they always want to be aware of, what is the duration in my portfolio?

Duration is the estimate of the price sensitivity of the bond to a change in rates—in this case, treasury rates, or LIBOR. So as those rates rise, people are concerned about how much price decline might I see in my bond portfolios? So, it makes sense that investors and advisors are thinking about duration in this type of environment.

Todd: Right, exactly.

Danny: Also Todd, given that rates have risen, there’s less opportunity cost for investors and advisors to look on the shorter end of the yield curve. The curve has been flattening—and we’ve been talking about this for the last few months—and as that curve flattens, there’s less and less opportunity cost for investing in the front-end of the curve or for shortening the overall interest rate exposure in a portfolio. Clients aren’t just giving up as much income as they may have a few years back. So, if they’re worried about interest rate sensitivity and duration, there is that opportunity to sort of tighten up their portfolio while not giving up a lot in terms of the coupon.

Todd: Yeah, we’re certainly seeing that out here in the field. You know, another topic I want to introduce is, and you can expand on it, we want to talk about what we call the leveraged loan market and those products that invest in that floating rate, leveraged loan piece of the fixed-income market. And included with interest rate risk, or interest rate duration if you will, is this thing called “spread duration,” and “spread risk.”

And I know that’s a particular topic that you’re doing a lot of work on. Can you talk a little bit about that?

Danny: Yeah, absolutely. And again, I think it’s a timely discussion. In the last three years, when we look at flows by Morningstar category, the ultra-short bond category has seen more than $60 billion in flows. But the bank loan category, the bank loan fund category, has seen more than $24 billion in flows over the last three years. So, again, as rates have been rising, clearly investors and advisors have been looking for—whether it’s ultra-short bonds, floating rate, or bank loans—to limit the amount of interest rate duration they’re taking on in their portfolios. And bank loans, or leveraged loans, have lower levels of duration. So if treasury rates or LIBOR increase, let’s say by a hundred basis points, a bank loan or leveraged loan may only have a duration of a quarter of a year. So, if those rates go up a 100 basis points you might see a negative price return of about 25 basis points, or a quarter of a percent.

On the flip-side, a five-year treasury note might have a four-and-a-half year duration, so if yields go up and treasury rates go up a 100 basis points, you lose 4.5% on the price return for that security. So, bank loans and floating rate loans have a place, and have been used very widely, but you’re absolutely right to mention spread duration. And that’s the piece that I think a lot of people aren’t fully appreciating. That’s the risk worth worrying about here.

I mean we all know there’s no free lunch, and so for an investor to be using a bond where they’re getting a five-plus percent coupon with a quarter of a year duration, when the 10-year treasury is at 3.2%, you know you’re taking risk somewhere. And the risk you’re taking is in credit spreads. And what we want to make sure that people are aware of is that a floating rate loan or a floating rate security may have a duration of a quarter of a year, but it might have a spread duration of several times that—four-and-a-half years, five years, three years. So if credit spreads widen out, just when people are thinking, “Hey, I’ve worked really hard to limit my interest rate duration,” they could be taking on this additional credit risk and really see negative price returns in that portfolio that they weren’t expecting.

And that’s the concern that we want to make sure people are aware of.

Todd: Yeah, and you’re absolutely right. And that brings up a good point, because generally, we’re seeing advisors that are, rightly so, reducing their duration in their fixed income and they’re going to the short end of the curve, and they’re using the leveraged loan market and stuff like this. And remember, this is, quote, “their safe money” that they’re using. So they don’t want to take undue risk with their fixed-income money. They want to spend their risk budget with their equities. So it’s a great topic to talk about—not only interest rate duration and risk, but spread duration. And I think you explained it really well.

So let’s talk about the global fixed income team’s view on duration that advisors might consider now in their portfolio. Obviously, you talked about reducing that duration, what are your thoughts there?

Danny: Well I think you hit on it earlier Todd, when you mentioned that advisors and investors have a “risk budget.” And we think an important conversation for investors and advisors to have today is: Where and how do we want to allocate that risk budget? High-yield credit spreads just set new post-crisis tight levels last month. So the balance of risk here is, we think, tilted to the upside, that there’s more risk that spreads widen from here than spreads continue to narrow further. And when you look at the bank loan, or leverage loan market, over the last several years, that’s an area where we have seen a deterioration in credit quality and some of the protections made to lenders. So there is an opportunity here, again, that people may be taking more credit risk than they fully appreciate. And that spread duration conversation and consideration, we think, needs to be included in that risk budget conversation that advisors are having with their clients.

Todd: Absolutely. Well Danny, let’s wrap this conversation up here. That’s all the time we’re going to have. I want to thank you for sharing these thoughts and all these nuggets with us today.

Danny: It’s been my pleasure Todd. I really appreciate the opportunity.

Todd: Until next time, I’m Todd Crawley. Thank you for listening to The Essential Practice podcast.

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