Long Dated Bond Funds: Beware of the Risk!

Recently, we have seen more pension scheme members expressing an interest in long dated government bond funds, ironically just as yields have started turning.  While investors are clearly being attracted by the returns of the last 3 years, the near 10% decline over the last month should serve as a warning to the suitability for investors. 

I have provided some key points below that should be considered to ensure that investors are suitably positioned:

1. Example: AAA/AA > 10 Year Government EMU Bond Fund

The AAA/AA > 10 Year Government EMU Bond Fund tracks the performance of the Merrill Lynch AAA/AA > 10 Year Government EMU Bond Index. This consists of long-dated government bonds from France, Germany, Belgium, Netherlands, Austria and Finland, sovereign states with a minimum credit rating of AA. (Long Term Bonds are typically considered to be those with a maturity of 10 + years). The duration is currently 14.66 and the yield to maturity is 1.23% (based on closing prices May 15^th 2015).

2. Performance of Government Bonds

Over the last six years as the world’s major central banks have cut interest rates to record lows and embarked on the purchase of government bonds as part of their quantitative easing programs, the demand for yield has increased, thereby increasing the demand for government bonds. As a result, bond prices have risen dramatically, delivering significant returns for investors, in particular long dated government bonds.

However, investors should be warned that while historical returns have been extraordinary, the outlook for returns is much more challenging. If interest rates remain low, returns will be relatively muted. However, they remain sensitive to a rising interest rate environment and to a reversal in investor sentiment. In particular, long dated government bonds are most exposed to a rise in interest rates.

3. Sensitivity of bond prices to a rising yield environment

The index has a duration of circa 15. Duration measures the sensitivity of bond prices to a change in yield whereby the longer the duration the more sensitive bonds are to fluctuations in yields; as a simple example, for every 1% change in yield there is an approximate 15% change in the price of the index. Therefore, if yields rise 1%, a fund with a duration of 15 would decline by roughly 15%.

Over the last few weeks we have seen how quickly yields can rise, causing bond prices to decline. The yield on the Merrill Lynch AAA/AA > 10 Year Government EMU Bond Index closed at a yield of 1.23% on Friday May 15^th, compared to 0.55% a month earlier. The impact has been a drop in the index of -9.55% over the last month, eroding most of the YTD gain. There is no downside protection on this fund.

4. Suitability

Therefore, for DC pension schemes long dated government bond funds are really only suitable for someone looking to match the price of annuity, i.e. those members who plan to buy an annuity at retirement.  Remember, since annuities are priced off long term AAA government bond yields, a decline in government bond yields make annuities more expensive to purchase.  (This has been the case over recent years). However, when yields rise government bonds fall in value and the annuities become more affordable. In effect, a a long dated government bond fund is an investment option that can be used lock in the cost of annuity as best as possible.

The fund is considered low risk from the perspective of the risk of default by AAA/AA rated governments. However, within a risk profile framework the fund is closer to medium risk to high risk because of the sensitivity to a rise in yields, known as interest rate risk.

We have communicated that this fund is difficult to position within a risk framework and should most appropriately be categorised as a matching fund. That is “suitable for investors who want to match the future cost of purchasing an annuity at retirement”.  For example, someone that is going down the ARF route has no concern about matching the cost of an annuity.

 To learn more on the mechanics of fixed rate government bonds read my recent blog update: The Mechanics of Fixed Rate Government Bonds.