author morris rajendran balakrishnan

Anthony Morris, Nomura's Managing Director, QIS (formerly of Fixed Income Research) in conjunction with Nomura analysts Srivaths Balakrishnan and Tamizhmarai Rajendran, shares his views on the risks and opportunities.

Achieving returns in bond markets was relatively easy over the last few decades. Excess returns (returns above cash) from holding bond benchmarks have been large, driven by the secular decline in yields since the early 1980s. But at current levels, the outlook for long-only bonds is less promising.

In this paper, we explore other ways to capture risk premia from interest rate markets. We consider evidence from JPY rate markets under the zero-rate policy and also the 1950s and 1960s, when even USD interest rates were low. We find that there is still life in interest rate exposure at low yields, if you know where to look. Doom mongering is both unwarranted and dangerous.

For example, many Western investors convinced themselves to short JGBs over the last 20 years. They thought the yields were too low. They thought they found the trade of a lifetime. Instead, they found “the widowmaker”, consistently losing money. As another example of the counterintuitive, we show that even as yields have fallen, it was possible to make solid returns in interest rate markets with an average duration exposure of zero.

The risks

There are plenty of reasons to be worried about interest rate exposure when yields are low, as they are now. Among them:

  • Bond excess returns tend to be lowest when yields rise from low levels

  • Term premia are at historical lows, last seen in the early 1960s

  • Duration is higher at low yields, making large losses possible

  • At low yields, bonds change character, becoming short volatility, i.e., left-tailed

The opportunities

Given these risks, it is no wonder some investors question whether they should have anything to do with interest rate exposure. But while there are reasons to be concerned, there are also reasons to be hopeful:

  • Duration is not the only way to earn returns in interest rates

  • Carry, value and momentum also deliver returns, especially at low yields

  • These alternative return sources have useful properties:

    1. They can play a larger role than duration at low yield levels

    2. They can be implemented in a duration-neutral format

    3. They have performed well in both live periods and back-testing


Read the full report on How to capture risk premia from interest rates, even when yields are low on the Global Research Portal.


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