Managing returns, controlling risks: duration management as a performance factor

Read the market analysis and fund positioning

The recent turmoil over trade tariffs shows that performance becomes a challenge in turbulent times. To survive, you need flexibility, active management and the full range of skills offered by a global multi-asset manager.

Our instruments include equities, fixed income, commodities and currencies. This gives us a wide range of options to take advantage of opportunities, manage risk and maintain portfolio stability in volatile markets.

Fixed-income investments are at the core of our portfolios. Credit spreads and interest rate sensitivity (duration) are the key control variables. Used correctly, they not only protect against unwanted market developments, but also help to identify specific opportunities in a challenging environment.

How yields really move

At the heart of the bond market is the yield curve. It shows the relationship between bond yields and maturities. Few other graphs attract as much attention, as its movements are seen as a seismograph for inflation expectations, economic momentum and monetary policy decisions.

Yield curves tend to change in three ways: The most common is a level shift - a parallel shift of all yields up or down (around 77% of movements). Less common are changes in steepness (17%) or curvature, whereby short, medium and long maturities move differently, providing an indication of interest rate expectations or enabling targeted positioning.

As changes in level and steepness account for the majority of curve movements, they are the focus of many investor strategies. Depending on the market view, a distinction is made between bull moves (falling yields) and bear moves (rising yields), as well as between steepeners (increasing steepness) and flatteners (decreasing steepness). These movements can also occur simultaneously.

Interest rate sensitivity explained simply - the role of duration

Duration measures how strongly a bond's price reacts to changes in its yield to maturity (YTM). Specifically, duration indicates the percentage change in price when the yield rises or falls by 1% (i.e. 100 basis points). This calculation is based on the assumption that the entire yield curve shifts in parallel.

Mathematically, duration is derived from a bond's maturity and coupon rate. It takes into account all cash flows - i.e. interest payments and principal repayments - and weights them according to when they are received.

An example: German government bonds maturing on 15 February 2035 - i.e. with a residual maturity of around ten years - currently have a duration of around 8.5. This means that if yields fall by 100 basis points, the price of this bond is likely to rise by around 8.5%, assuming a smooth movement of the yield curve.

Duration as an active management tool

Duration also plays a key role at portfolio level: portfolio duration is the weighted average of the durations of all bonds held in the portfolio, making it an important tool for active interest rate management.

At Ethenea, we use duration in a targeted manner to respond to anticipated movements in the yield curve and derive strategic advantages from them. A higher duration means that the portfolio value is more sensitive to interest rate changes – negatively when interest rates rise and positively when they fall. A lower duration reduces this sensitivity. Since portfolio duration can also be set to a negative value, it is not the sign but the amount of duration that is decisive: a duration of -6 has a similar effect to +6, only in the opposite direction.

Our interest rate management follows a clear principle: when interest rates are expected to fall, we lengthen duration; when interest rates are expected to rise, we shorten duration - even into negative territory if we are very confident. In times of uncertainty, we keep our interest rate sensitivity flexible and limited in order to exploit opportunities and manage risks.

Portfolio duration can be managed both through the duration of the bonds invested and through the flexible use of interest rate futures. Futures allow us to efficiently adjust interest rate sensitivity without having to physically change the underlying investments. As interest rate futures have many advantages - they are highly liquid, incur lower transaction costs, can be leveraged with little capital and offer maximum flexibility in portfolio management - they are our primary duration management tool.

Current outlook: Transatlantic interest rate environment

The interest rate landscape is now increasingly diverging between the US and the eurozone. In the US, the debate is dominated by fears of inflation triggered by the chaotic introduction of tariffs under the newly elected president. This development effectively deprives the Federal Reserve of any basis for further interest rate cuts. At the same time, the US is on an unsustainable debt path, which, together with the alienation of long-term creditors due to the tariff dispute, is likely to lead to a rise in yields.

In Europe, however, the picture is different: the economy is growing moderately and inflation appears to be under control. Import tariffs in the US could even have a deflationary effect in Europe, as the additional supply of goods will find its way to Europe instead of the US.

Despite the stimulus packages announced, Germany's government debt, the largest in Europe, remains relatively low. Although the European Central Bank has already cut interest rates seven times, ECB President Christine Lagarde recently highlighted the growing pressure on the European economy from US tariffs and indicated a willingness to cut rates further.

In our view, this has one clear consequence: the yield curves on both sides of the Atlantic are increasingly diverging. This creates valuable room for manoeuvre. US government bond yields are becoming the plaything of highly unpredictable politics: under these circumstances, they could rise further. At the same time, US Treasuries are currently disqualified as a safe haven investment. European government bonds - especially German bunds - are not only increasingly benefiting from their safe-haven status, but also face no upward pressure from the economic situation. We expect yields to fall moderately.

Conclusion: Thanks to our active duration management and selective positioning along the regional curves, we can respond to these macroeconomic differences in a targeted manner - and derive additional return opportunities from them. This is precisely why we believe it makes sense to increase our position in German government bonds at this time.

In a dynamic market environment, it is important not just to passively accept interest rate movements, but to actively change portfolio positioning. Sometimes longer, sometimes shorter - depending on what interest rates are doing. Strategic duration management allows us to stay in control, take advantage of opportunities and protect our investors' capital.