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Investors are “unnecessarily” reducing bond duration

Reducing bond durationFranklin Templeton Investments' bond chief has questioned why investors are reducing fixed income duration despite expectations that interest rates will remain low.

David Zahn, head of European fixed income, says investors are missing out on “precious” yield in a low-return environment by investing in bonds with low duration.

More than four in five professional investors in Europe do not expect European interest rates to rise by more than 1% over the next three years, according to research commissioned by Franklin Templeton Investments.

Yet 54% of the 300 European investors surveyed have actively reduced their duration over the last three years.

Bond duration is a measure of how sensitive bond prices are to interest rate movements.

Zahn said: “In a normal environment, where rates increase considerably, bonds would sell off substantially. In those circumstances there is cause to reduce your duration.

“But, according to our research, rates in Europe are barely going to reach positive territory by 2020, so investors are unnecessarily reducing duration and losing out on precious yield by fleeing to the short-end of the curve.”

The research found that 70% of investors were concerned about duration risk.

The research also found that just over three quarters of the investors believed that high yield bonds were overvalued and heading into bubble territory – though 75% of those surveyed will continue to buy high yield bonds over the next 12 months.

Franklin Templeton’s view is that although the underlying fundamentals of European high yield corporates are “broadly sound”, valuations have become stretched.

The survey also found:

  • 82% were concerned about rising interest rates and European Central Bank (ECB) tapering
  • 79% were concerned about returns
  • 69% were bothered about high pricing or the risk of an asset bubble within European fixed income (69%)

Many (70%) indicated that despite being aware of the risks, they felt their portfolios to be of low or moderate risk – a finding that Zahn described as surprising.

2018 has already seen bouts of isolated sell-offs in European bonds as markets try to price in a change in ECB policy. Zahn said investors could not afford to be “sleepy” and should become more active in European bond markets as volatility returns.

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