Time to add duration risk to bond allocations?

Inflation concerns ease

Tom Eckett

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Long-duration fixed income ETFs have been one of the most unattractive asset classes over the past decade, however, dampening inflation concerns makes an allocation to duration an appealing prospect once again.

While elevated levels of inflation remains the biggest risk to investors, recent data suggests it is not premature to be anticipating peak levels.

In the US, the most recent inflation print of 6.5% – the sixth consecutive monthly drop in a row – led the Federal Reserve to hike rates by 25 basis points, the smallest increase since March 2022, while inflation in the eurozone dropped to 8.5%, lower than analyst expectations.

This prompted a rotation to long duration from ETF investors with the iShares € Govt Bond 15-30yr UCITS ETF (IBGL) seeing $206m inflows over the past week, the most across fixed income ETFs listed in Europe, while the iShares € Ultrashort Bond UCITS ETF (ERNE) posted $251m outflows, the highest across the asset class, as at 2 February, according to data from ETFLogic.

While rates continue to rise, the market is signalling confidence central banks will halt their tightening cycles – especially in the US – towards the end of the year.

As a result, the recent central bank rhetoric – interpreted as dovish by the market – has driven a further rally in risk assets.

As Oliver Faizallah, head of fixed income research at Charles Stanley, said: “There were certainly hawkish undertones to the message, highlighting ‘more work to be done’, ‘ongoing increases until rates are sufficiently restrictive’ and ‘staying the course until the job is done’, however, markets paid much more attention to the overlaid dovish rhetoric.

“Chair Jerome Powell acknowledged that inflation has eased, and that disinflationary momentum is expected to continue in the near term. He stood by the December dot plot, implying a couple more hikes and no cuts to year-end as a base case, however, did not rule out the possibility of an early pivot should inflation come in lower than anticipated.”

As inflation concerns ease, the prospect of adding duration risk to portfolios becomes significantly more attractive despite the yield curve trading at its deepest inversion since 1980. This is mainly because longer-duration bonds are more sensitive to interest rate changes, the majority of which are currently priced in by markets.

Kevin Headland, co-chief investment strategist at Manulife Investment Management, said investors should look to “embrace” longer-duration bonds as the market starts to price in the risk of a recession.

“Since 1976, when the US was in a recession, the 10-year US Treasury yield fell by 35% on average,” he continued. “This means that the duration risk that was a headwind to bond returns eventually becomes a tailwind, as the combination of longer duration and falling yields tends to enhance bond returns.”

Overall, central banks have looked to maintain a hawkish rhetoric, a sentiment the market is simply not buying so far this year. As a result, if inflation continues to fall and recession risks remain, taking on duration could be an attractive play for investors this year.

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