Finlayson says the past year has spooked investors having had their fingers burned by duration risk during the historic selloff in 2022.
“A cruel quirk of fixed income assets is that the more expensive they get the riskier they become, as their duration risk rises,” he says. “This created the ingredients for the perfect post-pandemic storm that struck the bond market, causing it to have one of its worst years on record in 2022. Nothing lasts forever though. A number of key factors have emerged that mean duration risk can now be your friend once again and the question I would ask is if not now, when?”
Finlayson says that with the extreme repricing of government bond markets since their yield lows of 2020 – over that period 10-year UK Gilt and US Treasury yields increased by almost 450bps, with 10-year yields in Germany rising by around 350bps over the same period – sovereign bonds now offer compelling valuations. Not only are yields of around 4% “not to be sniffed at”, he argues, they also provide investors with an important income cushion and safe haven.
“Improved valuations mean that duration can again act as a risk-off hedge,” Finlayson says. “With a higher starting point than in recent years, yields now have room to fall in a flight-to quality situation. We saw this when the US regional banking stresses emerged in March and then again when First Republic failed in early May. With duration acting as a stabilising factor once more, this adds to its attraction at a time of macroeconomic uncertainty.”
Moreover, with inflation falling and economic activity slowing, Finlayson argues that investors need not, for the first time in 18 months, fear yields rising.
“Central Bank rates don’t need to move much higher thanks to falling inflation, weaker forward-looking data and financial system tensions,” he says. “We believe that we are now entering the end game for the hiking cycle of the major central banks: the arguments against hikes and in favour of a ‘pause’ are growing.”
For bond investors with any duration risk, Finlayson says this development is “crucial”, as it caps yields, reducing the downside to holding bonds.
“After the fall-out of the great-repricing of 2021/22, investors now no longer need to fear duration risk,” he says. “With the risk of higher yields now much diminished - replaced with the potential for lower yields - and Government bonds acting more like a risk-off hedge again, the benefits to investors of embracing duration risk within their fixed income allocations is clear.
“Of course, nothing ever moves in a straight line and the need to actively manage duration is key – both in terms of overall level of risk and which markets to get your duration from – but all biased from a starting point of having more rather than less duration risk.”
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