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Negative duration as a guard against a Treasury tumble

What had once been a fairly straightforward asset class focused on yields, maturity, and credit standing, global fixed income investing has now become an intense exercise to assess sovereign debts and currency changes. * * *

There are now more than 100 markets available for investments. The $90 trillion global fixed income market presents challenges and opportunities. Which path to take requires a clear concept of what outcomes are to be reached. One of the compelling considerations is the 'differentiated recovery', meaning that various economies are changing their monetary policies independent of the US.

“The US is no longer leading the charge to raise rates,” explained Brian Henry, Institutional Fixed Income Manager for Franklin Templeton Investments.

This is changing the landscape in global fixed income. The timing of rate changes not only affects the market price of those government bonds, it also changes the value of the currency. It is through thoughtful analysis that Henry identifies promising investment directions. There are still profits to be made in sovereign debt and emerging market debt, more so in the debt denominated in the local currency of the issuer versus that issued in USD by the foreign entity. He pointed to Brazil and other commodity driven countries as possible regions with opportunities worth following. Henry noted that nearly half of the global fixed income returns were currency related.

The US fixed income market has become particularly problematic. Treasury yields are extremely low, in part as a result of inordinate demand. The added spread for investment grade bonds has also reached historic lows. However, the US bond market cannot be overlooked. It is still the mainstay of institutional investors. At this point there is significant down-side risk, especially after the US Federal Reserve QE II wines-down this summer.

Henry and his team have moved to a protective stance for the US fixed income market. He has deployed a concept known as 'negative duration'. Duration is a measure of the sensitivity of the price of a bond to interest rate changes. A negative duration means that the market price of the strategy will rise when yields rise.

This will be of benefit to investors when the money starts flowing out of US treasuries. “When Treasuries decline, we make money,” notes Henry. Whereas most protective strategies utilise expensive futures and swaps, he employs a long/short Yen/USD position. This strategy is basically cost¬less and was derived from their empirical analysis that shows a positive Yen to Treasury correlation. So, by shorting the Yen he will profit when Treasuries go south. It is only a matter of time. Investors experienced a glimpse of this last fall when yields backed up with a vengeance, hammering portfolio prices.

Henry is first to say that forecasting the exact timing or magnitude of the rise in US Treasury yields is difficult. But one thing is certain, they will go up. There is little scope to fall below the current historic lows. When investors start selling out of their Treasury positions, the market price will fall and the effective yield on the fixed coupon will rise.

History has shown that this happens fast, much faster than typically anticipated. Some forecasts predict the 10-year US Treasury yield climbing to over five percent on a sell-off. Such a 200 bps point jump would wreak havoc with portfolios dominated by US Treasuries.

For historical comparisons, that would equate to a four percent real yield after compensating for one percent inflation in the US. A four percent real yield would be on the high-side historically. Henry explained it usually hovered in the range of a three percent real yield. It may be that investors now require an additional yield as a sort of 'risk premium' typically not associated with Treasuries. This could be due to the deterioration of the US fiscal situation and soaring balance sheet deficit. It would also be a result of concerns about future inflation from current high levels of monetary stimulation.

Henry and his team have constructed several global fixed income products that incorporate the negative duration on the US Treasuries, as well as select positions in sovereigns such as Korea, Malaysia , and Poland, amongst others. The Templeton Global Total Return Fund is the best of breed and seeks returns around the world from income, currency, and capital appreciation. There is also a Global Fixed Income strategy, in addition to the flagship Templeton Global Bond Fund.

More information is available on the website at www.templetonoffshore.com, only available to non-US persons. Institutional investors can contact distributor Christopher Lynch at clynch[AT]templeton.com.

“Two roads diverged in a wood, and I took the one less travelled by, and that has made all the difference” is from a well-known poem by Robert Frost. That has surely been the model for Sir John Templeton, who founded Templeton Investments. Templeton was a maverick, following leads to the far corners of the world and founding international investing almost 60 years ago. Now merged with Franklin Investments, Franklin-Templeton is one of the largest investment managers in the world.

In a luncheon speech this week for the CFA Society of Bermuda, global fixed income portfolio manager Brian Henry of Franklin-Templeton Investments talked about generating a superior return by a sharp analysis of the economic landscape and having the fortitude to follow a path less taken.

Patrice Horner holds an MBA in Finance, a FINRA Series 7 License, and is a Certified Financial Planner (CFP-US). Any opinions expressed in this article are not specific recommendations, nor endorsements of any products. Individuals should consult with their banker, insurance agent, lawyer, accountant, or a financial planner for advice to address their personal situations.

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Published March 12, 2011 at 9:00 am (Updated March 11, 2011 at 8:14 pm)

Negative duration as a guard against a Treasury tumble

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