LONDON -- In the midst of this year's once-in-a-lifetime rally in corporate bonds, some investors already sense the spectre of future interest rate rises destroying much of their gains.
A few are even starting to protect themselves while the risk is still months away and the price of hedging low.
"The biggest risk in credit over the longer term has moved from default risk to interest rate risk," said Jamie Stuttard, head of pan-European fixed income for Schroders, which had $32 billion (19 billion pounds) in fixed income assets under management as of end-June.
Corporate bond funds are sucking in investors because spreads still exceed historical averages, even after huge price gains during the rally. Spreads are the extra yield companies must pay over money market interest rates or government bonds.
At the same time, interest rates are at all-time nominal lows, with the Fed funds rate at zero to 0.25 percent.
Rates could rise amid a benign scenario of economic growth and central bank moves to keep inflation in check, or from a potentially destabilising oversupply of government paper as countries borrow more to fund deficits.
Investor desire to shield against rate rises has swollen Schroders' new SIF Global Credit Duration-Hedged Fund from 12 million to 250 million euros of assets in the past 10 weeks.
"The more retail the type of investor, the more conversations we have had about hedging interest rate risk," said Maria Ryan, director of investment strategy for Barclays Global Investors, with 301 million pounds in fixed income assets under management.
Duration hedging is the industry term for protecting against rate rises. Fund managers use tools such as futures or swaps to alter the period of time they are exposed to rate changes.
The demand for duration-hedged funds comes from certain kinds of investors such as endowments and individuals, not from insurance companies and pension funds, which already manage duration to match the timing of their liabilities or payouts.
BGI is now launching six new Credit Selection funds for retail and institutional clients -- three duration-hedged funds in dollars, euros and sterling and three non-hedged funds in each of those currencies.
"It's because we are seeing interest in both types of funds that we have had to do both," Ryan said. "It's coming from clients deciding whether they want rates exposure or not."
The higher a portfolio's duration, the more its value is affected by changes in rates.
BGI's long-only funds have an average duration of about 7 years. Its hedged funds have brought duration down so that investors are exposed to rate changes only three months out.
One BGI client has been discussing putting money into both hedged and long-only funds to bring his average duration to three years, Ryan said.
WHAT HEDGING ENTAILS
Both Schroders and BGI employ government bond futures. Each of the various hedging options has some drawbacks, but futures are the simplest, Ryan said. "There is no perfect solution."
Stuttard said hedging all duration risk via futures costs about 230 to 240 basis points out of a typical overall yield of 4.5 to 5 percent on an investment-grade bond portfolio.
At this price, it makes sense to hedge out rate risk if the investor expects 10-year government bond yields to rise by 40 to 45 basis points or more over the next 12 months, he calculated.
"The cost of duration hedging is quite low as futures are quite cheap to trade," Ryan said. "However to remove the interest rate risk, you generally have to give up some yield, and that yield give-up is quite significant at the moment."
Not all asset managers agree with the idea of bringing duration to zero.
"We have no plans to launch a bond fund with interest rate risk stripped out," said John Anderson, head of credit at fund management firm Gartmore.
Such a fund is likely to plummet in the event of another market downturn as investors flee risk assets to cash-equivalent havens, pushing rates lower and spreads wider, he said.
The fully hedged investor may turn out to be sorely disappointed if economic growth and interest rates bump along the bottom for many years, similar to Japan in the 1990s.
While near zero-duration funds are relatively new, fund managers routinely increase or decrease duration in portfolios.
Schroders has hedged away about two years' worth of duration to reduce the average to five years on its global credit portfolios, Stuttard said.
"I think it is a little premature to worry about inflation at this point," said Bob Michele, global chief investment officer of fixed income at JP Morgan Asset Management (JPM.N: Quote, Profile, Research, Stock Buzz).
But after interest rates broke through 3.25 percent on the 10-year Treasury bond in September, he cut the duration of his portfolio to three years from four.
"If I fell things are reflating more rapidly than I anticipated, I can sell more Gilt futures and Treasury futures until we get the duration back to zero if necessary," he added.
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