With so much concern about inflation and Fed rate hikes, bond investors should be paying close attention to the sensitivity of their portfolios to a change in interest rates. An important measure of this risk is called ‘duration’ which can tell an investor how much value a bond (or bond portfolio or fund) will lose if there is a change in the bond yield. For instance, a bond portfolio that has a duration of 5 years (duration is expressed in years since it is largely a function of timing) will lose 5% if the yield on the portfolio rises by 1%.
Duration is derived by considering the cash flows (coupons and principal repayments) from a bond investment. In general, lower coupon payments and longer maturities will increase a portfolio’s duration risk. This makes sense since lower coupons and longer maturities both mean that an investor’s principal is tied up for longer, so any change in bond yields will affect the investment for a longer period of time, and therefore have a greater impact on value.
This is an important point considering the way that the duration of typical fixed income investment vehicles have changed over the past few years. Immediately following the financial crisis, a standard intermediate-term bond index (like the well-known Barclays U.S. Aggregate Index) had a duration of close to 4 years. Today, the duration of that index is closer to 6 years. This is because, as interest rates headed lower following the crisis, bonds were issued with lower coupons. Also, many borrowers sought to take advantage of lower rates by issuing longer term bonds. As mentioned above, lower coupons and longer maturities both lead to higher duration. Since many fixed income funds or ETFs are benchmarked against these indices, there are a host of ‘core’ and ‘total return’ bond investments that now have longer duration than they did just a few years ago.
The potential risk is also greater at this time because the defensive cushion provided by the yields from bonds or bond funds is smaller today. If interest rates go up, bond investments lose value, and investors hope to recoup those losses from the bond yield. When yields are lower however, there is less protection, and so potential total losses are greater.
Consider this example: in 2009, a typical intermediate-term bond strategy might have had a duration of around 4 years and a yield of 3%. If interest rates had risen by 1% over the course of the following year, an investor would expect to lose around 1% for the year (3% yield minus the 4% loss due to duration risk). Today, that same strategy might have a duration of 6 years and a yield of 2.5%. So, if interest rates go up by 1% over the next year, an investor should expect to lose 3.5%. Clearly, the interest rate risk has gone up.
Now, there are some investors that favor higher duration exposure. The argument can be made that longer duration bonds are more likely to provide diversification from equities when it is needed most. In crisis situations in which there is a “flight to quality,” this may be the case, but in an inflation-driven market movement, both stocks and bonds may lose at the same time. Regardless, arguments in favor of longer or shorter duration are beside the point. The more important idea is that investors need to recognize the duration drift that has occurred in many ‘core’ and ‘total return’ strategies, and make a conscious decision regarding the duration of their bond positions rather than accepting unintended interest rate risks.
Have questions about bond risks? Contact me at andrew@lpastrategic.com.