As Canadians, we tend to love our balanced portfolios. The “60/40” split could almost be described as a household phrase for some. However, throughout the business cycle, we tend to focus predominantly on the market value risk of equities (commonly referred to as stock in a company). This fact is of good reason. Nevertheless, what I want to speak about today is the latter half of our balanced portfolio; that 40% of fixed income.
Fixed income is commonly referred to as the lower risk asset class, and although this is for the most part true, it still comes with risks. To name a few; Complexity, leverage, credit, & duration. This article will touch on duration risk as I believe it to be the least understood and one that will show its importance in the coming years. To understand duration risk, you first need to have an understanding of interest rates and our central banks.
As we entered this recession, most central banks acted with great speed and force to help prop up and stimulate our economies. The central bank of Canada (and the federal reserve in the U.S.) is called “the lender of last resort.”
It is given this nickname because if banks need to borrow money to clear up at the end of the day, they are able to borrow from the central bank at the rate in the upper band. They also have the ability to lend out excess cash to the central bank at the lower band. If bank “A” has $20m excess cash & bank “B” requires $20m to clear up at the end of the day, they are incentivized to work together as the lender will be able to receive more than they would have received at the lower band, and the borrower will pay less in interest than they would have at the upper band. This is how the target rate is achieved.
The second chart (above) shows us the historical target rate. With rates close to 0% and an unwillingness to create negative rates, the risk of further rate cuts is limited over the next few years. This likely means the next major moves in rates will be increases. Central banks across the developed world have communicated a commitment to keeping rates low while economies recover from the pandemic and following recession. However, we need to be forward looking in our planning as fixed income holdings with long durations could be drastically affected in a rising rate environment.
Quite simply, duration risk is the sensitivity of your fixed income holdings to changes in interest rates made by central banks. The higher the duration, the greater level of sensitivity to interest rate changes your fixed income investment will have. When planning for a recession, this can be a good thing as we would expect interest rates to decline which would create upwards pressure on those long duration holdings. However, with interest rates at all time lows, the yield to maturity (annualized return over the lifetime of that security) is also at all time lows. We would expect to see downwards pressure on their prices of those long duration holdings once interest rates start to rise.
As a simple rule of thumb, for every 1% increase in interest rates, our fixed income holdings would be expected to lose 1% of their value for ever year of duration. I took the liberty to reach out to a few portfolio managers to find out what the duration of the fixed income in their funds was and the most common answer was a duration of around 8. If interest rates were raised from 0.25% to 1.25%, this batch of funds would decrease in price by 8% and if rates were raised to a more “Normal” 2.25%, we would be subjected to a 16% decrease in market value.
I would not suggest that you remove your fixed income holdings as you need to stay true to your strategic asset allocation through all sections of a business cycle. You also need to invest based on your risk tolerance level. I do, however, believe that we need to start paying attention to the fixed income in our portfolios. There are many great options to generate your optimal portfolio in terms of volatility and return while also mitigating certain risks such as duration.
As always, please reach out if you have any questions at all, and never make these portfolio changes without first consulting professional advice.
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