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Don’t sell your long duration bonds
ETF Securities Fixed Income Research – Don’t sell your long duration bonds
Highlights
- We expect a gradual flattening of the US Treasury yield curve, providing grounds for holding long duration bonds.
- The major source of bond returns have come from coupons, not capital gains over the past seven years.
- Greater bond portfolio convexity gives the best returns in a volatile interest rate environment.
Global yields are picking-up
Global yields have bounced back from extremely low levels as expectations intensify about major central banks unwinding quantitative easing and normalising monetary policy. The shifting tone from central bankers in the western developed world has been driving a two-week global sovereign bond rout. In June and early July, global government bond yields rose by 25bps on average.
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The CFTC futures data shows net short speculative positioning at the front-end and net long speculative positioning at the long-end of the US yield curve, suggesting that investors are not yet convinced that economic conditions are improving to a point that drastically changes the GDP and inflation outlook. Additionally, the net long positions on the 10-year US Treasury notes is extreme: it has reached levels last seen in 2007.
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The Fed’s previous monetary tightening cycles have coincided with low asset price volatility and a bear flattening of the Treasury yield curve (short-end yields rising at a faster rate than the long-end). The 10yr – 2yr Treasury yield spread has already collapsed by 190bps since the end of the financial crisis and volatility is extremely low.
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The gradual pace of interest rate increases should place greater upward pressure at the front-end of the yield curve relative to the long-end. We believe the subdued inflation outlook coupled with the structural demand for long-dated bonds will partly offset the upward pressures on the long-end caused by the unwind of quantitative easing policies and the normalisation of central banks’ balance sheets. Thus, we expect a gradual flattening of the yield curve, with relatively low impact on long duration bonds.
Duration compensation at all-time low
Duration is a measure of a bond’s sensitivity to changes in interest rates. While the maturity of a bond is directly related to duration, the coupon rates and interest rates are inversely related to duration. For example, a bond with a duration of 5 would expect to lose roughly 5% if interest rates rose by 1%. A zero-coupon bond has a duration that is equal to its remaining maturity, while a coupon bond has a duration shorter than its maturity.
Typically, the longer the maturity, the higher the duration and the higher the interest rate risk. Bonds with longer duration fall in value with an increase in yields, while shorter duration bonds rise in value with an increase in yields. The average duration of global bonds has expanded after the financial crisis partly due to issuers taking advantage of cheaper long-term financing conditions permitted by extremely accommodative monetary policies worldwide. As a result, the duration risk compensation declined alongside the long-term yields before stabilising at historically low levels.
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In a context of rising interest rates, investors generally shift toward shorter maturity bonds or higher coupon bonds in order to reduce the interest rate risk (i.e. duration) in their portfolios. The Fed’s monetary tightening is likely to affect short-, medium- and long-term rates differently, which represents a challenge for bonds investors wanting to adjust duration for rising interest rates. In general, shorter maturity bonds have lower sensitivity to an increase in rates but also have lower coupon returns than longer dated bonds and might not fully compensate for inflation.
However, coupon returns typically represent the main contributor to the bond total return while in comparison capital gains are negligible1, particularly for long-term investors for diversification and income. Overall, adjusting duration is a trade-off between lower capital risk and higher coupon return. Therefore, short duration strategies might underperform long duration strategies in a rising interest rate environment.
Convexity provides returns when volatility rises
Another way of hedging against interest rate risk is through portfolio immunisation strategies where the average bond portfolio’s duration equals investors’ investment horizon. In this strategy, any changes to interest rates will affect both the price and the reinvestment of the coupon payments at the same rate so that the rate of return is fixed over the investment period. Institutional investors, such as pension funds, use them extensively. However, this strategy can be costly as it needs frequent rebalancing.
In the example below, we illustrate that having long duration bonds in an immunised portfolio can actually increase returns despite interest rate fluctuations. We have built two hypothetical immunised portfolios of two bonds with the same credit quality but with different coupon rates, maturity and duration. The portfolio 1 includes two bonds with a duration of 4 and 6 years, while the portfolio 2 includes two bonds with a duration of 4 and 16 years.
Both portfolios have the same average duration of 5 years, which matches our investment horizon. We conducted a static analysis where only interest rates vary around their current level of 2% to see how our two portfolios behave. Our example shows that portfolio 2, which includes a longer duration bond, gives the best returns at any level of yields. In addition, the immunised portfolio with the greater convexity2 – as defined by the curvature of the relationship between the bond price and yield – gives the best return regardless of whether interest rates rise or fall.
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As we head into global monetary policy normalisation, interest rate volatility will likely increase which would justify holding bond portfolios with higher convexity.
For more information contact:
ETF Securities Research team
ETF Securities (UK) Limited
T +44 (0) 207 448 4336
E info@etfsecurities.com
Important Information
This communication has been issued and approved for the purpose of section 21 of the Financial Services and Markets Act 2000 by ETF Securities (UK) Limited (“ETFS UK”) which is authorised and regulated by the United Kingdom Financial Conduct Authority (the “FCA”).
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Microsoft considers bitcoin, UBS launches tokenized fund, and MicroStrategy will buy $42B in BTC
Crypto markets faced a volatile week as key macroeconomic events approached, with the upcoming US presidential election and anticipated Fed rate decision fueling uncertainty in risk assets. Bitcoin (BTC) rose 1.7%, ether (ETH) declined 1%, Solana (SOL) fell 8.2%, and the Nasdaq Crypto IndexTM (NCITM) was down 0.5%.
Microsoft to consider bitcoin investment starting December
According to a new SEC filing, Microsoft is considering the possibility of investing in Bitcoin as a hedge strategy against inflation despite opposition from its Board of Directors. This move, by one of the world’s largest companies, would mark a significant step in institutional adoption for Bitcoin.
MicroStrategy discloses plans to buy $42B of BTC
The firm announced bold plans to raise $42 billion over the next three years to acquire more bitcoin. This new wave of capital will be split equally, with $21 billion from equity issuance and $21 billion from debt offerings, in a project called the ”21/21” plan. This move, led by founder Michael Saylor, underscores bitcoin’s potential as a valuable hedge against inflation and highlights its appeal as a strategic investment option.
UBS launches its first tokenized fund on Ethereum
UBS Asset Management has launched its first tokenized fund, the USD Money Market Investment Fund Token (uMINT), a money market fund built on the Ethereum blockchain, available through authorized partners. The launch supports the growing demand for tokenized financial assets and leverages distributed technology to enhance fund issuance and distribution, as well as UBS’s broader strategy to expand its tokenization services.
The fourth quarter got off to a strong start, with bitcoin (BTC) bumping up against its all-time high late in the month and the Nasdaq Crypto Index™ (NCI™) returning 7.2%.
Many crypto assets, however, struggled in October as the US elections and other uncertainties cast a shadow over bullish sentiment. Our CIO, Samir Kerbage, wrote about how the November 5th elections might impact investors and also joined a webinar with the CEO of The Digital Chamber to cover this topic in more depth. You can watch a replay of the webinar here.
As always, we are greatly appreciative of your trust in us and are here to answer any questions you may have.
- Your Partners at Hashdex
Market Review
October is typically a favorable month for crypto assets, particularly bitcoin (BTC). For this reason, the month is often referred to as “Uptober.” This year was no different: the Nasdaq Crypto Index™ (NCI™) posted a 7.2% gain, despite slight declines in the S&P 500 and Nasdaq 100 stock indices. However, unlike September, the vast majority of altcoins did not have a positive month.
In the first ten days of the month, the NCI™ gave back its gains from September. All NCI™ constituents recorded declines, except for Uniswap, which announced plans to develop its own layer two network on Ethereum. From then on, a strong recovery began, particularly for Bitcoin and Solana, which were up double digits by the 29th. This rally coincided with the sharp increase in Trump’s odds in election betting markets, and brought Bitcoin close to its all-time high. In the last two days of the month, crypto assets retreated, following the strong pessimism that overtook traditional markets.
Among NCI™ constituents, the positive highlights were Bitcoin and Solana, with gains of 10.6% and 9.0%, respectively. On the downside, Ripple dropped 18.6% due to the SEC lawsuit, while MATIC fell more than 20%, apparently due to migration to a new token called POL.
Among CF Benchmarks’ sectoral indices, the smallest drop was in the Smart Contract Platforms Index, mitigated by the performance of its main constituent, Solana. A similar effect was seen in the Digital Culture index, which dropped 7.6%, despite its largest constituent, SuperVerse, rising more than 20%. The Decentralized Finance (DeFi) index declined by 8.6%, with only Uniswap showing gains among its constituents. The Vinter Hashdex Risk Parity Momentum Index saw a small drop of 0.6%, heavily influenced by the sharp losses in Ripple and Near. In all five indices, the largest asset posted gains, but most other constituents did not.
In the near future, the US election results could serve as a trigger for a new all-time high in Bitcoin, as well as a recovery for smaller assets that are lagging this year. We remain optimistic about the development of the crypto asset class over the medium and long term.
Top Stories
Stripe acquires Bridge for $1.1B
Stripe acquired the stablecoin platform Bridge for approximately $1.1 billion, becoming Stripe’s largest acquisition and one of the biggest in the crypto sector. Bridge was created to compete with traditional payment networks like SWIFT and credit cards and helps Stripe’s growing interest in building a worldwide stablecoins infrastructure. This move boosts stablecoins credibility and signals an increasing fintech interest in Web3, potentially attracting more institutional investors and expanding blockchain-based financial use cases.
Robinhood launches crypto transfers in Europe
Robinhood Crypto has launched cryptocurrency transfers for customers in Europe, allowing deposits and withdrawals of over 20 cryptocurrencies, including BTC, ETH SOL. This was one of the most requested features by users in the region, and makes crypto transfers now available to all eligible Robinhood Crypto customers in Europe. This move signals the growing adoption of digital assets in Europe, boosting confidence in the asset class growth potential.
Bernstein predicts Bitcoin at $200,000 in 2025
Bernstein published a report predicting that Bitcoin could reach $200,000 by the end of 2025, driven by factors such as the halving, increased institutional adoption, and interest in inflation-hedging assets. Additionally, Bernstein foresees a growing integration of Bitcoin mining with artificial intelligence (AI), where about 20% of mining capacity could be redirected to AI by 2027. This underscores the growing integration of crypto and AI, driving technological advancements and boosting demand for both.
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