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The Basis is a quarterly presentation series by our Liquid Markets Group’s Multi-Asset Solutions team providing investors with insights into derivative structures and strategies, portfolio construction and other whole-of-portfolio investment topics.
In this edition, we dive deeper into one of the topics in this quarter’s The Basis: the benefits of duration hedging.
Credit sector construction can cause duration mismatch1
Fixed income sectors may invest across structures, public and private markets, and credit ratings. This flexibility allows investors to exploit a range of investment opportunities but may lead to unintended duration tilts. For example, the chart shows the mismatch between a commonly used fixed income benchmark and an off-benchmark asset mix that invests in corporate debt and leveraged loans.2
This mismatch can be hedged using a duration overlay
A duration overlay can be used to adjust overall portfolio duration. This reduces duration risk and can provide a better alignment with the relevant benchmark3. The overlay can be constructed using liquid futures contracts and requires only partial funding, making it capital efficient. The chart shows how a duration shortfall can be addressed using a duration overlay.
A duration overlay can reduce duration risk and tracking error
A duration overlay can be used to adjust overall portfolio duration. This reduces duration risk and can provide a better alignment with the relevant benchmark3. The overlay can be constructed using liquid futures contracts and requires only partial funding, making it capital efficient. The chart shows how a duration shortfall can be addressed using a duration overlay.
Managing a duration overlay
A duration overlay is typically constructed using a basket of bond futures. These are widely traded, highly liquid instruments that are available across a range of countries and tenors. The variety of available futures contracts allows the overlay to be customised to suit a range of different scenarios and objectives. For example, the country exposures and key rate durations of the overlay can be customised to provide an optimal risk management solution. Various factors should be considered when implementing a duration overlay.
- Data: What informaiton is available to design and manage the overlay?
- Maintenance and management: How often is the basket updated and traded?
- Basket design: What futures and weighting scheme is used?
- Rebalancing: How frequently are positions adjusted to target?
- Reporting: What information about the overlay is required?
Citations
- Source: Bloomberg, S&P, QIC. Date as at 31 December 2023.
- Benchmark is Bloomberg Global Aggregate Index.
- Benchmark is Bloomberg Global Aggregate Index.
- Source: Bloomberg, S&P, QIC. Date as at 31 December 2023.
- Source: Bloomberg, S&P, QIC. Data for the period 31 December 2016 to 31 December 2023.
- As at 31 December 2023.
Past performance is not a reliable indicator of future performance.
Further information
With a 20+ year track record of delivering better investment outcomes for our clients, we partner with our clients to manage more than A$23 billion in cash and fixed income assets, and A$86 billion in derivatives exposures6. Our team has the specialist skills and deep experience to manage the full spectrum of liquid market investment solutions, including cash and fixed income, a broad set of multi-asset derivative solutions and implementation.
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