Eco Investor September 2014

Fixed Interest

How Interest Rates Affect Fixed Interest Funds

A handy guide to how changes in interest rates will affect the value of a fixed interest fund is the concept of duration. Understanding this idea will help investors to know how much the value of their units could go up or down when official interest rates change.

Every fixed interest fund has a duration that can be provided by the fund manager. Term deposits and bonds are for a set time then they mature and are repaid. The duration is based around the number of years until the assets mature and the yield of the assets until they mature. This allows for the calculation of a number called the modified duration that measures how sensitive a fund is to changes in interest rates.

Tim Kelly, portfolio manager Fixed Interest with Australian Ethical Investment, says that "Duration (or "Macaulay Duration") is a measure of the weighted average term to maturity of a bond's cashflows. Modified Duration takes the duration measure and is a measure of the sensitivity of a bond's price to interest rate changes." For example, the Australian Ethical Fixed Interest Trust has a modified duration of 4.3x, while the assets in the Australian Ethical Cash Trust have a maximum modified duration of 1x.

To work out the affect of an interest rate change, an investor multiplies the modified duration by the change in interest rates. Mr Kelly says the practical affect of the Fixed Interest Trust having a modified duration of 4.3x is that if yields across the curve fall by 0.25 per cent, the trust will rise in value approximately 1 per cent (4.3 x 0.25 = 1.075 per cent). If it is a 0.25 per cent rise, the value of the trust will be down about 1 per cent.

This also helps us to see how the Cash Trust is lower risk and more capital stable than the Fixed Interest Trust. With the Cash Trust's modified duration of up to 1x, a 0.25 per cent change in interest rates will produce up to a 0.25 per cent change in capital value.

The modified duration also makes it much clearer to see the affect on a fund of a prolonged period of rising or falling interest rates. Fixed interest funds are not set and forget investments. Depending on the modified duration, a series of rising interest rates can significantly reduce the value of a fund, while a series of rate cuts can significantly increase the value.

Another issue is that the modified duration does not stay constant. It changes with time as each bond and term deposit matures, as bonds are added or sold from the portfolio, and as yields change.

The benchmark for the Fixed Interest Trust is the UBS Composite Bond Index, and this also has a modified duration, currently 4.3x. Mr Kelly says the benchmark is regularly updated to include new bonds that are issued and to remove maturing bonds, and that Australian Ethical manages the Fixed Interest Fund so that the weighted average modified duration of its portfolio is as close as possible to the benchmark's overall modified duration.

Mr Kelly says that investors cannot be certain about the movement in capital value with future moves in interest rates, but the modified duration measure is a useful guide to the exposure of the trust to changes in the yield curve. What investors should follow is how closely this aligns with the benchmark. Is a fund at a neutral position, attempting to match the benchmark exposure, or positioned longer or shorter than the benchmark?

Investors also need to know where we are in the interest rate cycle, and even more so as the modified duration gets greater than 1. The correlation of modified duration and interest rate changes suggests that the best time to buy into a fund with a modified duration of greater than 1 year is at or near the top of the interest rate cycle. Each cut in interest rates will add to the value of the fund. Conversely, a good time to sell is at or near the bottom of the interest rate cycle, as each rate increase will reduce its value.

This helps explain why some investors move between asset classes as interest rates change. But if investors want to change their asset allocation, it opens the questions of where to, when, and by how much?

And it still leaves the big questions asked by everyone - which way will interest rates go and when? The chatter is that we are at or near the bottom of the interest rate cycle, but it may be sometime before they change or start going up.

Mr Kelly says the position of the Fixed Interest Trust is currently neutral for the coming six months- "there being both upside and downside risks in the market at present".

"Market risks on the downside stem from the looming "normalization" of official rates by the US Federal Reserve. The upside risk is that yields continue to compress in response to a protracted period of low-returns globally, most recently exacerbated by talk of the European Central Bank preparing to undertake a Quantitative Easing program. As with the moves by the US Fed, the exact timing and quantum of such a move by the ECB remain highly uncertain."









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