FIXED INCOME FORWARD RATES
SUMMARY
A duration-based approach
to portfolio design limits the
amount of alpha generation
available to bond managers.
Using forward rates instead
allows bond managers to
use their view of economic
conditions and assess what it
means for future yields.
A fund manager is thus able to
take a series of uncorrelated
positions, leading to the
possibility of greater alpha
while measuring risk at the
same time.
remember how the concept
of duration was
derived. Duration implicitly
assumes that the yield
curve can only move in
parallel, in other words
that each of the ten oneyear
forward rates is perfectly
correlated.
l The real world
In the real world it turns
out that these ten oneyear
rates are not perfectly
correlated at all. Looking
at the real behaviour of
bond prices shows that the
key assumption underlying
the concept of duration is
false, and yet the concept
Graph 1: One year forward rates
Yield %
7
6
5
4
3
2
THE RATES PROCESS
Avg 10 year
yields (Feb)
Avg 10 year
yields (Apr)
persists as the main measure
of bond portfolio risk.
There is, however,
another way. The key is
in the use of forward rates
instead of spot rates. If
we look at all the ten
different one-year forward
rates in isolation, instead of
grouped together to make
a ten-year bond, we have
the chance to find several
uncorrelated factors that
drive the yield curve.
Careful examination of
historic data validates this
approach, showing that
forward rates from different
sections of the yield
curve have much lower
correlations than spot
The typical fixed income fund manager normally makes one duration
decision: they decide whether to go long or short duration based on
their expectation of whether yields will rise or fall. Taking a ten-year
gilt as an example, the flaw with this process is that it assumes that
all of the ten individual annual rates, the average of which provide
the ten-year yield, all move in parallel. This, of course, is virtually
impossible.
Graph 1 shows the yield on a ten-year gilt in February and April
2009. The broken turquoise line shows the yield in February, with
the turquoise blocks above and below the line illustrating the ten
individual annual forward rates on which this average is based. The
broken blue line, and the blue blocks, show the average yield and
forward rates in April.
In contrast to the single decision process used by the typical
fixed income fund manager, our rates process makes use of all
the available information to analyse each year separately. We then
generate separate forecasts for each of the individual annual forward
rates. If we expect the rate to fall, then we will take a long duration
position in that forward rate (the positive bar in Graph 2); and if
we expect rates to rise we will take a short duration position (the
negative bar in Graph 2).
Source: Ignis Asset Management
1
1 yr forward yields (Feb)
1 yr forward yields (Apr)
0
1yr 1/1yr 1/2yr 1/3yr 1/4yr 1/5yr 1/6yr 1/7yr 1/8yr 1/9yr
Source: Ignis Asset Management
rates. Trading forward
rates, therefore, potentially
offers a large diversification
benefit.
Another advantage of
forward rates is that they
are directly related to the
underlying economy in a
way that a ten-year bond
yield is not.
With this in mind it
is easy to see why different
forward rates are
uncorrelated.
l Difficult to predict
Consider the impact of the
Bank of England’s recent
quantitative easing programme.
Different fund
managers will have different
views on whether or
not the Bank will succeed
in stimulating the real economy;
the accuracy of their
view ultimately reflects
the manager’s skill level.
However, let’s consider
a manager who believes
the Bank’s programme will
succeed and is thus bullish
on the real economy.
This view implies low
short-term interest rates
due to increased liquidity
but higher longer-term
rates because the return
to economic growth will
eventually lead to a return
of inflation and monetary
tightening.
Trying to estimate the
implication of this view
Graph 2: Duration
for the price of a tenyear
coupon bond is very
difficult: the near-dated
cash flows become worth
more, as short-term rates
are lower, and the fardated
cash flows are worth
less, as long-term rates are
higher.
The net effect is ambiguous
and difficult to predict.
Using duration to measure
the exposure leaves the
manager with uncertainty
about how to optimally
implement the view and
so, even if the view is correct,
much of the alpha
that should be generated
could be lost.
On the other hand,
working out the impact on
the ten individual one-year
forward rates is simple:
short-end forward rates
will go down and long-end
forward rates will go up.
Thus, translating the economic
view into a forward
curve position is straightforward
and efficient.
Looking at forward rates
offers a clarity of analysis
and position formation.
This frees a fund manager’s
thinking and allows them
to devote all their attention
to forming accurate
economic views and constructing
the best possible
portfolio to reflect those
views in a range of uncorrelated
positions, leading to
greater alpha.
44 PORTFOLIO ADVISER [www.portfolio-adviser.com] JANUARY 2010
Basis point value of positions
0.100
0.075
0.050
0.025
0.000
-0.025
Duration
-0.050
1yr 1/1yr 1/2yr 1/3yr 1/4yr 1/5yr 1/6yr 1/7yr 1/8yr 1/9yr
Source: Ignis Asset Management
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