Bond investors are being unwittingly exposed to higher duration risk, warns Kames Capital

Investors are unwittingly being exposed to higher duration risk as debt issuers increasingly seek to lock-in low borrowing costs for longer periods, raising the interest rate sensitivity of bond benchmarks, Kames Capital is warning.
Bond yields have declined to record lows in recent years, thanks in part to the extremely accommodative monetary policy implemented globally by central banks. In response, corporates and governments are issuing long-dated bonds in an effort to lock-in all-time low borrowing costs for extended periods.
“One of the biggest concerns that bond investors’ face right now is duration risk – the risk that a rise in interest rates creates a fall in bond prices,” says Mark Benbow, fixed income fund manager at Kames Capital. “Considering that the duration of bond benchmarks has been rising for the past 20 years, investors are wise to be mindful of this risk.”
The most pressing issue facing investors, says Benbow, is that as issuers borrow for longer periods, the level of duration in bond benchmarks rises – a phenomenon occurring at the same time as lower yields are forcing institutional investors into lower-rated or longer-dated bonds to generate income.
“This is a noteworthy combination,” he says. “Ever-lower yields mean more supply (and greater demand) of longer-dated bonds, but for investors’ bond portfolios it can mean more duration risk for less return potential.”
This problem is particularly acute, Benbow points out, for passive investors who have no control over the issues to which they are exposed. “Index-based investors face the risk of following this trend and being forced into longer duration than desired in response to the changing characteristics of fixed income markets,” he says. “Indeed, many fixed income portfolio managers are being dragged longer in duration as their underlying benchmark duration has increased, therefore exposing the end investor to additional interest rate risk by default rather than design.”
Benbow says Kames does not chase benchmark duration as it does not believe debt indices are the basis for a successful investment, concentrating instead on identifying alpha-generating ideas as the starting point for building portfolios.
“As a high yield fund manager I take additional comfort in the different characteristics offered by the high yield asset class,” he says. “Unlike in other markets, duration has been falling over the last 20 years. This offers us significant opportunities to invest in shorter-dated, higher yielding assets and build concentrated, high conviction portfolios.”