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Beware the bear

Fund manager decisions to shorten bond durations bode ill for the sector, reports John Kenchington

Signs of consensus on a bond bear market are emerging as fixed-income fund managers last week started to slash their duration positions.

Fixed-income managers such as Aegon Asset Management and Old Mutual Asset Managers say they are cutting their average bond durations as measures of inflation inch higher.

Expressed in years, duration on a bond indicates how much time on average the bondholder will have to wait before being handed coupon payments and final repayment.

The longer the duration, the longer on average the bondholder has before receiving payments and this is a crucial calculation for bond fund managers in assessing how exposed they are to any interest rate rises, which cause bond prices to fall.

Interest rates are viewed as more likely to rise when inflation looks set to become entrenched in the economy and as inflation fears grow, fund managers are cutting their durations.

Co-manager of Aegon Asset Management’s £391m sterling corporate bond fund Iain Buckle says: “We lowered the fund’s interest rate risk to an extent towards the end of last month.

“After a period of weakness through November and the start of December, the gilt market had consolidated somewhat during the middle of the month.

“This was a good opportunity to further reduce the fund’s duration relative to peers, given our long-term view that global interest rates are on a steady upward path.”

Old Mutual’s £780m corporate bond fund manager Stephen Snowden last week said he is deploying new tools on the company’s bond funds to slash its average duration to as low as zero.

Snowden, who delivered the best return in the 85-fund IMA sterling corporate bond sector last year for the second year in a row, believes persistent inflation is a concern.

He says: “Flexibility on managing duration is key and will have a real impact on how we manage the fund.

“Active duration management and potentially reducing modified duration to as low as zero is designed to enable us to respond to volatility and risk and produce more consistent returns.”

However, Snowden does not expect the Bank of England’s monetary policy committee to raise interest rates this year, despite inflation being persistently above target.

But with money supply at a relatively high level, he feels it is prudent to reduce interest rate risk.

Snowden says: “The risk in PIIGS (Portugal, Italy, Ireland, Greece and Spain) remains high but it is probably time to be re-entering some of the more defensive sectors, such as telecom operators and utilities. We do not generally see the entry point for financials in these markets.”

TwentyFour Asset Management managing partner Mark Holman says: “The inflationary pressures in the UK, which the MPC said would subside 12 months ago, are even greater today and still growing. If we couple this with the gradual and ongoing improvement in the UK economy, the case for raising rates has grown.

“The first hike will be in the second half of the year with perhaps a second before year-end. However, it is easy to make a case to act sooner.

“If we do not see signs of pre-emptive action, we think the market will start taking its own view around long-term inflation and punish the gilt market, which is something that has already crept into recent price action.”

Royal London Asset Management economist Ian Kernohan says: “Aside from the UK, we expect developed world inflation to stay low, given the scale of spare capacity. Even in the UK, where inflation is set to stay above target, thanks in part to a second rise in VAT, we do not expect underlying inflationary conditions to gain traction.

“Sustained periods of high inflation in the UK typically result from too rapid economic growth relative to supply, which leads to a marked tightening in labour market conditions.”

Despite this, Kernohan believes the Bank of England will raise rates to maintain the credibility of its inflation management abilities.

He says: “We expect the BoE to raise rates in 2011 to maintain its anti-inflationary credentials. If the BoE were not to act, assuming the economy continues to grow at a reasonable rate, there would be a serious risk that high-inflation expectations would become ingrained.”

Henderson Global Investors economist Simon Ward says a theory known as the Kondratyev cycle now suggests a bear market in bonds is on the horizon as rate-setters are likely to take action.

He says: “The interest rate cycle is in a similar position to 1984 but with yields about to embark on a sustained rise.

“The trigger for such a trend change could be a hawkish shift in monetary policies during 2011, led by emerging economies, as the well advanced upswing in wholesale price index inflation extends and broadens out to consumer prices.”



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