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Clients were asking how comes the capital gains showed by the funds were so low if we report a duration of almost 5 and rates are getting lower

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  • September 2019
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  • Clients were asking how comes the capital gains showed by the funds were so low if we report a duration of almost 5 and rates are getting lower

Context:The strategy aim to be interest rate insensitive and the modified duration reported is a limited model for the sensitivity of FRNs

Impact for the fund: Positive as the strategy aim to reach a high and steady income from the coupon payments and not taking a view on rates to try to capture short term capital gains

It is clear from the graph below that the fund is not reflecting his modified duration in his sensitivity to rates, and the reason for that is in the limitation of the model of Modified Duration.

We are currently working with GAM & MSCI to be able to validate a OAS duration, but let me go more into details

 

 

The reason for this is that modified duration is a very good indicator for classical bonds i.e. securities with a fixed coupon and fixed maturity. But the fund has only 14% of such securities (fixed-dated bond), explaining why the fund reacts differently than his modified duration to interest rates.

For example, modified duration doesn’t know that Tier 1 securities issued under Basel II will lose their eligibility as regulatory capital by 2022 (this is why we call them grandfathered Tier 1), meaning that issuers will buy them back by latest 2022 or in less than 3.5 years. This means that grandfathered fixed perpetual (8.7% of the portfolio) should not have a modified duration higher than 3.5, if taking regulatory changes into account. With a stated modified duration of 17.2, this is the biggest contributor to the duration for the fund but in reality it is very insensitive to rates. Taking a conservative assumption of a duration of max 3.5 for fixed perpetual, one can already deduct 1.2 from the fund’s duration, or from 4.7 to 3.5. In addition, we own discounted floating rate notes (FRNs) in order to mitigate the interest rate risk on fixed-dated bond. FRNs trade at discount because of their low coupon. The coupon is a floater so that any rise in interest rates means a higher coupon and a higher price. So the capital gains that we generate on FRNs, when rates get higher, off-set capital losses that we would experience on fixed-dates bonds. By taking the OAS (option adjusted spread) duration for the FRNs, one can deduct approximately another point from the fund’s duration.

 

Taking both elements into consideration (i.e. impact of regulatory changes as well as OAS duration), the fund’s duration can be adjusted from 4.7-1.2-1= 2.5.
MSCI gives us a OAS duration for the USD fund as of end of August of 2.62 which confirms the above approximation
Going forward you should see the OAS duration be added to the documentations for the funds

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