Fixed Income
This is a marketing communication for professional investors only.
Capital at risk. Past performance does not predict future returns.
Navigating the fixed income landscape over the past few years has been anything but straightforward, with frustrated clients only adding to investors' problems. The so-called stable, protective portion of portfolios—bonds—became both volatile and unexpectedly correlated with risk assets. Matters were made worst by the performance of index-linked bonds, which were touted as "inflation protection" but delivered dismal results during a period of rising inflation.
Amid monetary policy uncertainty, an inverted yield curve, and mounting client pressure, many investors gravitated toward the seemingly safer option: positioning at the front end of the yield curve. By adding a measured allocation to credit, those who adopted this approach have likely managed to weather the past three years relatively well.
Short duration outperforming long duration
Past performance does not predict future returns.
Source: Morningstar 31/10/2021 to 31/10/2024
I don’t think any of us anticipated the free lunch of 4–5% tax-free cash yields on short-dated gilts to last this long. Over the past three years, we’ve indulged in this "gilty" pleasure of easy, risk-free returns. However, in doing so, we may have lost sight of the primary reason we allocate to fixed income in a multi-asset portfolio. The purpose of fixed income isn’t solely about generating yield—if that were the case, we’d just allocate to high-yield or emerging market debt. Fixed income plays a crucial role in protecting the overall portfolio during a crisis. The 60/40 framework is about more than just matching a client’s risk tolerance through desirable levels of volatility and drawdown. Its real power lies in enabling investors to rebalance between two negatively correlated assets during a crisis. Coupons, while welcome, are secondary when it comes to protecting a portfolio over the short-term.
Consider the case of 60/40 portfolios in 2020: a portfolio with quarterly rebalancing outperformed one that didn’t rebalance by 150 basis points (12% vs 10.5%). If you rebalanced at the market trough in March 2020, your outperformance rose to 200 basis points (12.5%). By comparison, a portfolio mixing cash with 60% equities and rebalancing at the same trough had a larger drawdown, greater volatility, and a lower return of just 10.7% by year-end. This demonstrates that rebalancing is a hugely powerful tool—one that’s sometimes overlooked by investors. Its effectiveness can be supercharged by holding more duration, allowing for greater capital appreciation from bonds, which in turn enables buying equities at deeply discounted prices.
Past performance does not predict future returns.
Source: 01/01/2020 to 31/12/2020. Global Equities: Solactive GBS Large & Mid Cap.
That said, it’s hard to fault investors for favouring short duration in recent years. The market environment hasn’t demanded the protection that bond duration traditionally provides. Historically, equity markets experience a 10% or greater drawdown roughly once per year and a 5% or greater drawdown around three times a year. Yet over the past two years, we’ve only seen three drawdowns of more than 5% and none exceeding 10%. Perhaps this is the new normal, where long-duration bonds are no longer necessary. But that seems unlikely. I would strongly encourage investors to assess their portfolio’s duration in comparison to the benchmark, which typically falls in the 8–10-year range. A prolonged rate-cutting cycle, akin to what we experienced in the 2010s, could result in significant underperformance for portfolio with shorter duration.
Drawdown
Past performance does not predict future returns.
Source: Morningstar Direct
As investment professionals, we understand the rationale for including duration in a portfolio. However, many clients are likely still bearing the scars of holding bonds during the challenging years of 2021 and 2022, making it a difficult case to convince them to add duration back into their portfolios.
The argument I would present is that, given current starting yields, the return profile for bonds is far more attractive and asymmetrical compared to 2020. Additionally, unlike in 2020, there is now meaningful potential for capital upside from long-duration bonds. For instance, if the 10-year yield were to rise by 100bps from current levels (a plausible scenario), your total return over two years would be approximately +3%. Compare this to the same scenario in 2020, where a similar move would have resulted in a -8% total return over the same period. On the flip side, a 100bps decline in yields from here would generate a total return of approximately 15%, compared to only 8% in 2020. Back then, you were holding an asset yielding just 0.77%, a rate unlikely to even cover an investor's fees and with limited capital upside given rates, in theory, are capped at zero. Today, by contrast, you’re being paid 4.2% to an insurance assets with a compelling asymmetric return profile.
Expected Return on 10yr Gilts Over 2 Years
Source: Bloomberg, yields: 0.77% (04/08/20), 4.221% (03/06/24)
Returning to a neutral duration position feels like a daunting prospect, especially with the lingering risk of inflation making a resurgence. Historically, equity and bond correlations tend to rise during periods of elevated inflation, undermining the diversification benefits that are central to the 60/40 model. Looking ahead there are several potential landmines on the horizon that could reignite inflationary pressures. Geopolitical tensions in the Middle East or an escalation of the Ukraine-Russia conflict could push energy prices higher, raising the spectre of a 1970s-style stagflation scenario. Meanwhile, Donald Trump’s proposed policies, despite his promise to "end inflation," include measures that could have inflationary consequences. Reduced immigration and mass deportation would likely drive wages higher, while renewed trade wars and tariffs could increase prices for everyday goods and services in the U.S. Closer to home, excessive borrowing by the Labour Party could keep upward pressure on yields.
If we decide to return to neutral duration, the question becomes: how will we manage duration on an ongoing basis? Attempting to sidestep negative bond periods by predicting interest rates and inflation is a near-impossible task. History has shown that humans have a poor track record when it comes to forecasting the future path of interest rates. We are all prone to a host of cognitive biases, but one particularly relevant to interest rate predictions is the bias toward mean reversion. When rates are low, markets tend to anticipate imminent Fed hikes; when rates are high, they often price in the next move as a cut. The chart below highlights just how consistently the market has struggled to predict future UK base rates.
The markets implied view of future interest rates vs the actual UK base rate
Source: Bloomberg 01/01/09 to 01/11/23
Knowing that duration management will be hard, should we attempt to do it? If we are to do it, how much mental capacity should we allocate to it? Investors, like anyone else, only have so many hours in a day and so much mental bandwidth to dedicate to decisions. Steve Jobs famously wore the same outfit every day—his signature black mock turtleneck, blue jeans, and New Balance sneakers—to avoid what he called “decision-making fatigue.” By simplifying one area of his life, he could conserve his energy for more critical decisions. Managing a portfolio is no different. Investors should focus their time and energy on decisions they are likely to get right and that will have a meaningful impact on portfolio performance.
It’s also worth noting that while bonds may represent 40% of a 60/40 portfolio, they contribute only around 6% of the portfolio’s overall risk, with equities dominating the risk profile. For an asset class with such a minor impact on risk, wouldn’t it make more sense to outsource duration management and reallocate that mental bandwidth to areas like equities, where decisions have a greater impact?
Source: Bloomberg. Equity: Solactive GBS Large & Mid Cap Equity. Bond: Bloomberg Global Aggregate
The question, then, is: who should manage this duration? Historically, investors have turned to strategic bond funds, but these come with their own set of issues. Strategic bond funds often carry significant allocations to credit, which diminishes the negative correlation benefit that bonds provide during crises. For example, during the Global Financial Crisis (GFC), the strategic bond sector fell alongside equities as credit spreads widened.
Performance of bond indices during the Global Financial Crisis Period
Past performance does not predict future returns.
Source: Morningstar. 01/05/2007 to 31/02/2009
This issue is even more pronounced today, with credit spreads sitting at historically tight levels. The potential for further capital upside from spread tightening is likely limited, and the additional carry of roughly 50 basis points may not be enough to compensate for the added risk.
Historical Credit Spreads - 5yr Investment Grade
Past performance does not predict future returns.
Bloomberg: 12/10/2011 to 31/10/2024
Another key consideration is the underlying key rate duration exposure of the strategic bond fund compared to its weighted average duration. In a crisis, the 10-year part of the yield curve tends to be the most reactive, typically falling the most. Beyond 10 years, rates are less responsive and more influenced by long-term inflation expectations and pension demand for long-duration bonds. Interestingly, during the GFC, the highest returns came from 10-year gilts—not from longer-dated bonds, as one might intuitively expect.
The problem with some strategic bond funds is that their substantial allocations to high-yield bonds (with 3–5 years’ duration) and investment-grade credit (5–7 years’ duration) reduce the overall duration of the fund. To compensate, some funds barbell these allocations with very long-dated government bonds. As a result, while the fund’s weighted average duration may appear to align with benchmarks (8–10 years), it may have limited direct exposure to the critical 10-year segment of the curve where much of the protective value lies during crises. This mismatch raises questions about the suitability of strategic bond funds for managing duration in portfolios designed for crisis protection.
The key risk of moving back to neutral duration is the possibility of entering another period of elevated equity and bond correlations, which often occur during inflationary periods. Could an allocation to index-linked bonds provide protection in such scenarios? As we painfully learned in 2022, index-linked bonds
safeguard against falling real yields, not necessarily against rising inflation.
Past performance does not predict future returns.
Bloomberg: 12/10/2011 to 31/10/2024
I would also question their diversification benefits, given that other assets like equities, property, infrastructure, and gold are similarly correlated to real yields. While index-linked bonds are an excellent tool for liability matching (particularly for pension funds) and can perform well during stagflation, they may not effectively mitigate the downside of the 60/40 framework in periods when equity and bond correlations rise. This makes their role in a diversified portfolio less clear-cut when it comes to protecting against such risks.
In summary, shifting from short-dated gilts to a neutral duration position has the potential to improve the overall risk, return, and drawdown characteristics of a 60/40 portfolio. However, the odds of successfully managing duration tactically are slim, given the difficulty of accurately predicting interest rate movements. If outsourcing duration management, it’s crucial to select a strategic bond fund with limited credit exposure to maintain the diversification and downside protection that bonds are meant to deliver.
At Atlantic House, we offer the Dynamic Duration Bond Fund, a purpose-built tool for managing duration in investors' portfolios. This fund employs a systematic, signal-driven investment strategy designed to outperform conventional bond funds across a broader range of inflationary and deflationary environments. By utilizing three equally weighted signals from the US and UK inflation markets, the fund dynamically adjusts its allocation between bonds and inflation protection. In inflationary periods, it tilts toward inflation-protected assets, while in deflationary environments, it shifts to traditional bond exposure.
Here’s why the fund may appeal to investors considering a return to a neutral duration stance:
Systematic Duration Management: The fund’s positioning is guided entirely by market-derived signals from inflation markets, eliminating the need for subjective human predictions about the future path of interest rates. For those currently relying on human judgment to manage duration, this fund can act as a duration management diversifier.
Inflation Without the Duration: The fund uses UK and US inflation swaps for inflation protection, which, unlike index-linked bonds, carry no embedded interest rate duration. This allows the fund to deliver positive returns in environments of rising interest rates and inflation.
No Credit Exposure: The fund focuses solely on four risk exposures: UK and US 10-year interest rates and UK and US 10-year inflation rates.
Targeting the 10-Year Rate: The bond exposure is concentrated on the 10-year part of the curve, which historically provides the most protection during equity market drawdowns.
Fair Value: With an AMC of just 0.25%, the fund is competitively priced —only 5bps higher than the iShares Global Government Bond ETF.
The Dynamic Duration Bond Fund offers a unique, systematic approach to duration management, providing flexibility and protection across varying market environments while remaining cost-effective. It’s an attractive option for investors seeking to enhance portfolio resilience without relying on traditional, human-driven strategies.
Bloomberg: 12/10/2011 to 31/10/2024
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The Fund invests in government bonds. All bonds will be investment grade (i.e. at or above S&P rating BBB- or deemed equivalent). If any of the bonds the Fund owns suffer credit events the performance of the Fund could be adversely affected
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This is a marketing communication issued by Atlantic House Investments Limited and does not constitute or form part of any offer or invitation to buy or sell shares. It should be read in conjunction with the Fund’s Prospectus, key investor information document (“KIID”) or offering memorandum. Atlantic House Investments Limited is authorised and regulated by the Financial Conduct Authority FRN 931264. Atlantic House Investments Limited is a Private Limited Company registered in England and Wales, registered number 11962808. Registered Office: One Eleven Edmund Street, Birmingham. B3 2HJ.
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The Atlantic House Dynamic Duration Fund is a sub-fund of GemCap Investment Funds (Ireland) plc, an umbrella type open-ended investment company with variable capital, incorporated on 1 June 2010 with limited liability under the laws of Ireland with segregated liability between sub-funds.
GemCap Investment Funds (Ireland) plc is authorised in Ireland by the Central Bank of Ireland pursuant to the European Communities (Undertakings for Collective Investment in Transferable Securities) Regulations 2011 (S.I. No. 352 of 2011) (the “UCITS Regulations”), as amended.
Gemini Capital Management (Ireland) Limited, trading as GemCap, is a limited liability company registered under the registered number 579677 under Irish law pursuant to the Companies Act 2014 which is regulated by the Central Bank of Ireland. Its principal office is at Suites 22-26 Morrison Chambers, 32 Nassau Street, Dublin 2, D02 X598 and its registered office is at 7th Floor, Block A, One Park Place, Upper Hatch Street, Dublin 2, D02E762. GemCap acts as both management company and global distributor to GemCap Investment Funds (Ireland) plc
