January 11, 2013
Topic Paper July 16, 2015
The Role of Empirical Duration in Managing Interest-Rate Risk PERSPECTIVE FROM FRANKLIN TEMPLETON FIXED INCOME GROUP®
Eric Takaha, CFA Senior Vice President Director of the Corporate & High Yield Group Franklin Templeton Fixed Income Group® Eric Takaha is the director of the Corporate & High Yield Group, Franklin Templeton Fixed Income Group, a member of the firm’s Fixed Income Policy Committee and portfolio manager of Franklin Strategic Income Fund. He is a Chartered Financial Analyst (CFA) Charterholder and a member of the CFA Society of San Francisco, CFA Institute and the Stanford Business School Alumni Association. He received a B.S. from the University of California, Berkeley and an M.B.A. from Stanford University. He joined Franklin Templeton in 1989.
In the United States, the fixed income story today Finding the “True Risk” in a Portfolio: An Inexact Science is a cautionary tale of rising interest rates lurking We believe there is growing recognition among the investment around the corner. Most investors probably have community that risk is a primary lever in the investment process. While effective modeling is built on a foundation of transparency, heard this story for a while now, surmising that no single measure—including the concepts discussed here—will the end of the bond bull market will mean it is provide a complete picture of the “true” risk inherent in any individual investment or portfolio. Risk professionals must look at game over for their fixed income portfolios. a wide variety of data points from a host of sources and risk Franklin Templeton’s Eric Takaha does not see measures. that as a foregone conclusion, but he also believes plotting a fixed income strategy to meet Diversifying beyond Core Fixed Income Do rising US interest rates mean investing in bonds or bond funds tomorrow’s challenges requires a willingness to is destined to become a losing proposition? That the “bond think about investing in the sector a little bubble” that some say has been building for decades is set to burst? While we do not know the exact timing around future differently, perhaps looking beyond traditional interest-rate moves, we think investors should consider managing borders, benchmarks and duration models, and their fixed income portfolios with a defensive posture—one that seeking out strategies that have the potential to can not only potentially generate income, but also aims to position provide what could be considered a natural hedge for the least-nausea-inducing ride. In our view, part and parcel of that approach should look beyond the US interest-rate curve, against interest-rate risk. aiming to provide income generation and potential return across a broad range of fixed income markets globally.
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We believe that in the decade ahead, the strategies that have relied on falling interest rates to generate returns could be challenged. For that reason, we think investors should think about diversifying beyond core fixed income in their portfolios—looking beyond the US rate curve to provide potential income and return across a broad range of global fixed income markets—but also be keenly focused on building and evolving a dynamic riskmanagement strategy. When discussing interest-rate risk, the conversation often turns to duration. An examination of duration (see sidebar), which takes into account bond maturity, coupon and call features, can offer a mechanism to help manage the risk—and the volatility—in fixed income investments that accompany interest-rate movements. For example, maintaining a shorter duration in a portfolio tends to result in lower interest-rate-related volatility. We view traditional core and passive fixed income strategies with concentrated duration exposure as likely ill-suited to succeed in coming years. In our view, a truly unconstrained strategy has more flexibility to potentially weather and exploit varying market conditions and diversify the drivers of return in a portfolio. This result becomes more apparent when compared with relatively duration-heavy core fixed income portfolios, particularly in a rising-rate environment. Various fixed income indexes and US Treasuries have experienced relatively strong correlations (see table below), indicating that duration has been the predominant risk, and yield
WHAT IS DURATION? One of the main risks fixed income investors are faced with is interest-rate risk—the risk that as rates rise, the value of their investments will decline. Duration is a measurement of a bond’s—or a portfolio’s—sensitivity to interest-rate movements. It measures the number of years required to recover the true cost of a bond, considering the present value of all coupon and principal payments received in the future. Generally, the higher the duration, the more the price of the bond (or the value of the portfolio) will fall as rates rise because of the inverse relationship between bond yield and price. Example: A bond with a duration of one year would lose 1% of its value if interest rates rise 100 basis points, or 1%. A bond with a duration of five years would lose 5% of its value if rates rise 100 basis points. In a bond fund, that would, in theory, equate to a 1% and a 5% drop in the NAV, respectively. For bonds with embedded options, an option-adjusted measure of duration is used to account for changes in expected cash flows, known as option-adjusted duration (OAD).
movements have been the primary driver of returns. Conversely, a strategy with relatively low correlation—and even negative correlation—to US Treasuries historically could be a more efficient allocation to fixed income. The table below shows how crosscorrelations across the fixed income market can potentially enhance diversification—without guaranteeing profits or protection against risk of loss—in an unconstrained portfolio that has the ability to exploit these different sectors.
Table 1: Fixed Income Cross-Correlations 10-Year Correlations Ending June 30, 2015
US Core Bonds US Investment Grade Corporates Mortgage-Backed Securities
1.00
0.82
0.88
0.85
0.77
0.23
0.69
0.72
-0.02
0.54
0.82
1.00
0.56
0.44
0.68
0.61
0.54
0.46
0.38
0.57
0.88
0.56
1.00
0.81
0.65
0.03
0.59
0.65
-0.16
0.41
US Treasuries
0.85
0.44
0.81
1.00
0.59
-0.27
0.61
0.76
-0.46
0.30
TIPS
0.77
0.68
0.65
0.59
1.00
0.40
0.63
0.40
0.22
0.45
High-Yield Bonds
0.23
0.61
0.03
-0.27
0.40
1.00
0.17
-0.15
0.88
0.36
Global Bonds
0.69
0.54
0.59
0.61
0.63
0.17
1.00
0.47
-0.12
0.28
Non-US Bonds
0.72
0.46
0.65
0.76
0.40
-0.15
0.47
1.00
-0.33
0.39
Leveraged Loans
-0.02
0.38
-0.16
-0.46
0.22
0.88
-0.12
-0.33
1.00
0.27
Municipals
0.54
0.57
0.41
0.30
0.45
0.36
0.28
0.39
0.27
1.00
Index Name
Asset Class Represented
Index Name
Asset Class Represented
Barclays US Agg Bond TR USD
US Core Bonds
Credit Suisse HY USD
High-Yield Bonds
Barclays US Corp IG TR USD
US Investment Grade Corporates
Citi WGBI USD
Global Bonds
Barclays US MBS TR USD
Mortgage-Backed Securities
Citi WGBI NonUSD LCL
Non-US Bonds
Barclays US Treasury TR USD
US Treasuries
Credit Suisse Leveraged Loan USD
Leveraged Loans
Barclays US Treasury US TIPS TR USD
TIPS
Barclays Municipal TR USD
Municipals
Source: Morningstar. Correlation measures the degree to which two investments move in tandem. Correlation will range between 1.00 (perfect positive correlation; where two items historically always moved in the same direction) and -1.00 (perfect negative correlation; where two items historically always moved in opposite directions). Indexes are unmanaged, and one cannot invest directly in an index. Past performance does not guarantee future results. For illustrative purposes only; not reflective of the performance of any Franklin Templeton fund.
For Financial Professional Use Only. Not For Public Distribution. The Role of Empirical Duration in Managing Interest-Rate Risk
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Duration and Risk: Thinking Empirically For the sake of simplicity, we refer to duration—which measures the change in the value of a security in response to a change in interest rates—interchangeably with “modified duration.”1 While examining modified duration does have merit, it is not without a few flaws when used in risk modeling for a diversified fixed income portfolio. Duration is a model-based metric and tells only part of the performance story. While interest-rate movements drive a meaningful portion of fixed income returns, there are other factors, including credit spreads and currency movements, among others, that also drive returns. We believe that taking an empirical approach to reviewing a portfolio’s sensitivity to interest-rate movements helps gain a more complete understanding of the true interest-rate risk inherent in our portfolios. We believe an examination of empirical duration—calculating a bond’s duration based on historical data over a specified time period—goes one step further. This examination requires regression analysis, essentially using historical data to determine what has happened to a portfolio in different market environments. If a rise in interest rates is anticipated, maintaining a low or negative duration might be considered to avoid potential portfolio losses. Negative duration may seem highly desirable in a rising-rate environment, but it can result in undesirable levels of volatility and risk. And, while the value of a portfolio with negative duration might increase when rates rise, there is the possibility rates may remain steady or even fall, resulting in potential loss. Our goal is to have a complete understanding of the interest-rate risk in our portfolio and position based on our views across a variety of markets and sectors. We cannot completely remove the risk elements, but we can try to influence the interest-rate experience of a portfolio. Our approach to risk management is three-pronged: It involves recognizing the risks we are taking, making sure they are rational, and determining that there is appropriate reward potential. In a portfolio comprising highly duration-sensitive assets, yield curve movements will dominate performance. However, there are other potential drivers of performance in a flexible, unconstrained fixed income portfolio—such as Franklin Strategic Income Fund— including various spread sector and global exposures. By expanding into these sectors, we aim to reduce the reliance on interest rates as a driver of performance. The primary performance drivers in our strategy are sector allocations and rotation decisions, along with security selection within those sectors. So, we examine empirical duration not necessarily as a primary performance driver, but as part of our overall riskmanagement toolkit.
Chart 1: Option-Adjusted Duration (OAD) vs. Empirical Duration (EmpDur) of Franklin Strategic Income Fund As of July 6, 2015 4 3 2 1 0 -1 -2 -3 7/6/12
1/6/13
7/6/13
1/6/14
Analytic OAD 120-Day EmpDur vs. 10-Yr Treasury
7/6/14
1/6/15
7/6/15
260-Day EmpDur vs. 10-Yr Treasury
Source: Franklin Templeton Investments, Bloomberg. Figures reflect certain derivatives held in the portfolio (or their underlying reference assets).
In the chart above, you can see that in addition to carrying a stated duration of less than four years, Franklin Strategic Income Fund’s empirical duration has been much lower than the OAD would indicate, as part of our low-duration strategy to position for a rising-rate environment in the United States.
Corporate Credit and Interest Rates The pricing of certain bonds tends to be impacted more significantly by factors other than changes in interest rates, such as economic growth, corporate earnings patterns and temporary market shocks. This is particularly true for more credit-oriented sectors. Rising interest rates tend to accompany healthy economic growth, and when growth is healthy in an economy, corporate assets are generally supported. On the surface, one would likely expect the impact of rising rates on the performance of a corporate bond fund would be a decline in the NAV (net asset value) to some degree, as predicted by the OAD. However, the actual outcome may differ, as confirmed by a study of empirical duration and the recognition of the negatively correlated relationship of credit spreads to interest rates. In 2013, for example, the longer-maturity US Treasury and highquality fixed income markets in general saw negative total returns, while high-yield and leveraged loans both had positive returns.2 Simply, the OAD estimates what the model says will happen in theory, but the theory does not always work perfectly. While examining empirical duration does not guarantee or predict future performance, it can help gain a more complete understanding of the interest-rate risk coming from those exposures.
For Financial Professional Use Only. Not For Public Distribution. The Role of Empirical Duration in Managing Interest-Rate Risk
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Putting It into Practice So what does this all mean in terms of portfolio positioning? Our goal for Franklin Strategic Income Fund is to build a welldiversified portfolio that has a variety of performance drivers beyond interest-rate movements. From a portfolio-durationpositioning standpoint, incorporating a view of empirical duration alongside model-based durations can help provide a more complete picture. Additionally, as mentioned, our unconstrained approach allows us to look across a broad range of credit markets globally for potential income and return, regardless of interest-rate movements in one particular market.
Eric Takaha on: US ECONOMIC GROWTH When we evaluate the fundamentals in the US economy, we see a fairly constructive environment. It appears the United States is finally moving toward more trend-like growth of around 3% in 2015–2016, following the more sluggish pace of economic growth in the wake of the 2007–2009 financial crisis. This growth is due to a continued improvement in the consumer, corporate and housing sectors. In our view, the US economic picture remains relatively upbeat compared to other parts of the globe that are confronting somewhat more challenging conditions.
Many US investors seem to be so singularly focused on the impact of rising rates—to the point of panic in some cases—they fail to examine what has actually happened to various fixed income investments over similar periods historically. We have found that over time, interest-rate moves do not often play as large of a role in a broadly diversified fixed income portfolio as one might think.
CONSUMER DEMAND
The impact of rising rates on a fixed income portfolio (for better or worse) ultimately depends on what asset classes and market segments one is invested in. It is also worth pointing out the importance of the “income” component within fixed income—the primary attraction for many investors to the asset class—that we think can be achieved using myriad tools and market exposures. What it takes is a broad view of the sectors that comes from a truly unconstrained approach. And, we think it requires a thoughtful examination of the risks, one that looks at risk modeling through a variety of different lenses.
While we cannot predict the exact timing of interest-rate moves, we would expect to see future Federal Reserve (Fed) interest-rate increases as gradual and measured. Given market expectations for higher US rates going forward, we think a more limited exposure to the US Treasury curve could be a prudent move in the current environment.
Eric Takaha’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.
Many Americans are feeling a “wealth effect” that comes not just from rising prices for real estate and financial investments but also, and more immediately, from the sharp drop in oil prices in late 2014. The combination of these factors along with strong jobs growth could, we think, spark an increase in consumer demand ahead.
US INTEREST RATES
CORPORATE CREDIT Thinking about corporate credit in 2015, the strong US dollar and weakness in commodity prices may put some pressure on first-half 2015 earnings, and companies are becoming a bit more aggressive with their balance sheets and more willing to take on more debt. Over the last several years, in general, US companies have been able to refinance at lower rates, so their interest costs have remained low. However, we think that effect may start to change if and when the Fed begins to raise short-term rates. Overall though, the proportion of companies in the market that is considered distressed remains very low, the default rate has remained below longer-term averages, and liquidity levels appear generally adequate, in our view. As a result, we have tended to view pullbacks as potential buying opportunities. That said, prolonged lower commodity prices could challenge certain issuers and cause distress in related sectors, although at this time, many issuers in these industries seem to have liquidity to weather some period of lower commodity prices, and we think valuations have largely priced in this risk.
For Financial Professional Use Only. Not For Public Distribution. The Role of Empirical Duration in Managing Interest-Rate Risk
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WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in the fund adjust to a rise in interest rates, the fund’s share price may decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in a loss of principal—a risk that may be heightened in a slowing economy. The risks of foreign securities include currency fluctuations and political uncertainty. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and less liquidity. Investing in derivative securities and the use of foreign currency techniques involve special risks and, as such, may not achieve the anticipated benefits and/or may result in losses to the fund. These and other risk considerations are discussed in the fund’s prospectus.
IMPORTANT LEGAL INFORMATION This commentary reflects the analysis and opinions of the author as of July 16, 2015, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided are valid only as of July 16, 2015, and may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, strategy, industry, asset class or security. An assessment of a particular country, market, security, investment, asset class or strategy may change without notice and is not intended as an investment recommendation nor does it constitute investment advice. Statements about holdings are subject to change. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. Your clients should carefully consider a fund’s investment goals, risks, charges and expenses before investing. To obtain a summary prospectus and/or prospectus, which contains this and other information, please call Franklin Templeton Sales and Marketing Services at (800) 223-2141 or visit franklintempleton.com. Your clients should carefully read the prospectus before they invest or send money.
CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute. 1. Modified duration is a formula that expresses the measurable change in the value of a security in response to a change in interest rates. 2. US investment-grade credit is measured by the Barclays US Corp IG TR USD Index; leveraged loans by the Credit Suisse Leveraged Loan USD Index; high-yield bonds by the Credit Suisse HY USD Index. Indexes are unmanaged, and one cannot directly invest in an index. Past performance does not guarantee future results. See www.franklintempletondatasources.com for additional data provider information.
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