"Currently most managers do not think that will be the case though. They believe defaults will rise but not by an unusually high amount."
Artemis fixed income manager Grace Le elaborates, saying, "We expect default rates to rise from their current floor but with companies broadly in better shape than they were two decades ago."
She adds: "Current valuations are reflecting a lot of negativity. We think we are being compensated for the risk."
In the current market, Pimco's spokesperson says it is time to "focus on capital preservation, flexibility and liquidity”.
What is duration risk?
Duration is a measurement of a bond’s interest rate sensitivity, and considers a bond’s maturity, yield, coupon and call features
Generally, the longer a bond’s duration, the more its value will fall as interest rates rise, because when rates go up, bond values fall and vice versa.
An investor expecting interest rates to fall during the time the bond is held would find bonds with a longer duration appealing because the bond’s value would increase more than comparable bonds with shorter durations.
According to Rathbones' head of fixed income Bryn Jones, it is "purely mathematical".
He said: "This is because each rise in interest rates leads to a fall in prices. Therefore, quid pro quo, shorter duration assets are less sensitive to such moves."
Muzinich & Co's Michael McEachern, co-head of public markets, explains the pull-to-par effect.
"Short-dated bonds of creditworthy companies tend to display less price volatility than their longer-dated counterparts, as they don’t often trade below par. When they do, they tend to reverse back to their par value quickly.
"They also tend to converge back to par as the bond approaches maturity. This is known as the ‘pull-to-par’ effect. The ‘pull-to-par’ effect also helps short-dated bonds recover from drawdowns."
How can one mitigate duration risk in a portfolio? The shorter a bond’s duration, the less volatile it is likely to be.
For example:
- A bond with a duration of one year would lose 1 per cent if rates were to rise 1 per cent.
- In contrast, a bond with a duration of 10 years would lose 10 per cent if rates were to rise by that same 1 per cent.
- Conversely, if rates fell by 1 per cent, bonds with a longer duration would gain more while those with a shorter duration would gain less.
Those investors concerned about wide fluctuations in the value of their bond holdings should consider a bond strategy with a very short duration.
Investors who are more comfortable with these fluctuations, or who are confident that interest rates will fall, should look for longer duration.
Inflation risks
If duration risk increases because interest rates rise, rates only tend to rise if they are being used to combat inflation.
Interest rate risk is entangled with inflation expectations.
According to Fairview Investing's Gavin Haynes, "inflation is the enemy of fixed interest markets and rising inflation expectations lead to price falls for most bonds".
Higher inflation is likely to lead to rising interest rates, which makes the return from fixed interest less attractive in real terms.
