Ever since the Federal Reserve pushed interest rates down to zero during the 2008 financial crisis, bond investors have been fretting about the looming threat of an inevitable rate hike, which could have a generally negative effect on bond prices.
So far, that hasn't happened, but as
2015 shapes up for what would be the first rate hike since 2006, bond investors and financial advisers are homing in again on duration as a fundamental risk-navigation tool.
Trouble is, duration, as a measure of bond's sensitivity to interest rates, shows only part of the risk profile, particularly when it comes to bond funds.
“Duration is really meant to be applied to a single bond, and for that reason it is a very imperfect risk metric when you're talking about a portfolio of bonds,” said Justin Sibears, managing director at Newfound Research.
“In the
context of bond funds, duration is not pointless, but it is a gross oversimplification of risk,” he added.
In the most basic sense, duration serves the dual purpose of showing investors the average-weighted amount of time it takes to get your money back on a bond investment, and also provides an estimate of how a bond's price will move based on a change in the yield.
The second part is what investors and advisers tend to dwell on as the threat of higher rates grows larger.
For example, if a 10-year corporate bond has a 1% yield and a duration of four years, the price of the bond will move down 4% for every percentage point increase in yield.
That's the kind of scenario that keeps financial advisers and their clients obsessing over duration. And it could be a real concern for anyone investing in individual bonds. But for the vast majority of advisers who are gaining bond exposure through mutual funds, duration might be getting too much weight as a measurement of risk.
For starters, not all bond yields respond the same way to short-term rates set by the Fed, and mutual funds typically hold a variety of bonds.
Consider one fund that owns just two bonds, each with 10-year durations, and another fund that owns a 5-year-duration bond and a 15-year-duration bond.
Both funds would have durations of 10 years, but the yields on the individual bonds are not likely to respond the same way to an interest rate hike, meaning that the effects of duration would be different for each fund.
As a general rule,
bonds that pay a higher coupon will have a lower duration, which is why a zero-coupon bond's duration will be equal to the bond's maturity, meaning that a 10-year zero-coupon bond will have a duration of 10.
The $125 billion Pimco Total Return Fund (PTTRX), to take a real-world example, has a posted 30-day yield of 1.27%, a portfolio duration of 4.87 and an average bond maturity of 10.47.
“Duration only matters if the yield on the bond you own changes,” not whether the Fed raises rates, explained Jason Brady, portfolio manager and head of global fixed income at Thornburg Investment Management.
“The duration figure is a good thing to think about, but the correlation between a lot of bonds and Treasuries is not one,” he added.
Neil Sutherland, manager of the Schroder Long Duration Investment Grade Bond Fund (STWLX), said a too-strict focus on duration has forced investors to lose out on income for nearly five years.
“The theory is that when the Fed raises rates, all things being equal, longer-duration bonds will fall more than short-duration bonds,” he said. “But what people are not considering is that longer-dated bonds are more sensitive to other things, such as global relative value to other bonds, and if you have traded this market purely on [duration] logic over the last 18 months you would have lost a lot of money.”
Scott Colyer, chief executive of Advisors Asset Management, describes duration as “probably the most misunderstood measure in bond land today,” suggesting that duration has even drawn attention away from the other major part of bond risk, which is credit quality.
According to Morningstar Inc., the high-yield bond fund category, as of February, had an effective duration of 3.69, which is lower than bond fund categories investing in intermediate government, intermediate corporate, long-term corporate, long-term government and world bonds.
The long government category had the highest duration of 14.24, followed by long-term corporate bond funds at 9.54.
“Clearly, low-credit quality, lower-duration bond funds are most likely to have a higher yield, but I don't think short-duration junk bonds is the key,” said Steven Wruble, chief investment officer at FolioMetrix.
“There are many pieces of the risk equation that need to be looked at,” he added. “I think just focusing on duration doesn't give the whole picture.”
From Mr. Colyer's perspective, the bond market in general is being skewed by monetary policies that have held rates artificially low and are now pushing for inflation and higher interest rates.
Duration, meanwhile, has come along for quite a ride, which is illustrated by the evolution of yield and duration in the BarCap Aggregate Bond Index.
Twenty years ago, the index was yielding more than 7% with a duration of 4.5 years. Ten years ago it was yielding 2% with a duration of 5.25%. And today the index is yielding 1.6% with a duration of more than 5.5%.
“It's almost a Catch-22 for bond fund investors, because if they're worried about interest rates they want a shorter duration, and they think the only way in this low-rate environment to earn anything is to add duration,” said J. Brent Burns, president of Asset Dedication.
“And from a bond fund manager's perspective, the job is to keep current investors happy and bring in new ones,” he added. “In order to do that in an environment like this they have to reach to reach for yield, which usually adds duration.”
