Zero balancing duration risk

Putnam Investments, 10/24/13

In a hasty retreat from bond markets, investors pulled around $67 billion from bond funds in June. Ironically, economic growth is taking a lot of the blame. Driven by concerns over the Fed's economically "contingent outlook" for ending its massive bond-buying program starting sometime in the closing months of 2013, investors have begun to second-guess their rate-sensitive income strategies.

With no widespread expectations of U.S. economic prospects suddenly dimming in the months ahead, it is plausible that more investors could pull even larger sums from bond markets if interest rates continue to rise in advance and in the wake of Fed policy action.

Rate risk can be hedged What investors forget or may not know is that interest-rate risk can be hedged away. "Traditional" bond funds that have endured large outflows may not have the tools to hedge their rate bets, so to speak, but alternatives such as absolute return funds and flexible multi-sector bond funds frequently do have the wherewithal to implement such strategies.

Selling a futures contract, as we described in a recent post, is one method of hedging out rate risk. To take a simplified example, if a manager buys 10-year Treasuries and simultaneously sells Treasury futures, any negative effect that rising rates might have on the bonds would be offset by price appreciation on the futures contracts. (Of course, if rates were to fall, the contract position would decline in value while the bond exposure itself could see its value rise.) But these types of derivatives-based strategies are not the only way to hedge out interest-rate risk. Another strategy with a similar hedging effect is to buy agency interest-only (IO) mortgage-backed bonds.

Agency IOs: The attraction of prepayment risk The performance of agency IOs is influenced primarily by how quickly homeowners can refinance their mortgages. What drives refinancing activity? Interest rates. As rates fall, it becomes desirable for homeowners to refinance their loans. For the IO investor, a falling-rate environment implies that the bond is likely to be called away due to high mortgage prepayment rates, requiring the reinvestment of proceeds at prevailing lower rates. But in a rising-rate environment, mortgage owners are less likely to refinance their loans. And the longer the underlying mortgages remain outstanding, the longer they produce cash flows, which enhances the value of the IO security and its desirability on the secondary market.

In this way, IO securities also impart a negative duration effect to a portfolio of bonds that otherwise do carry duration risk. Combined with other strategies, like selling futures and swaps, these securities can effectively help neutralize duration risk, insulating a portfolio from the negative effects of rising rates.