The Federal Reserve is widely expected to begin hiking interest rates this year, which typically has a negative impact on bond prices. In response, many financial advisors have been focused on duration and interest rate sensitivity when analyzing their clients’ bond portfolios. The problem with this approach is that non-government and government bonds often don’t act in the same manner.
For instance, the 2008 economic crisis saw government bonds gain nearly 28% and non-government investment grade bonds fall nearly 4%, according to Morningstar, Inc. (MORN) data, despite the similar durations, interest rate risk, and other characteristics. The opposite dynamics occurred in 2009 when the market snapped back. The irony is that bonds are usually a part of a client’s portfolio designed to have less risk.
In this article, we’ll take a look at why financial advisors and their clients may want to look beyond duration when evaluating bond portfolios.
Bond Duration Primer
Bond duration is a measure of how many years it will take for the price of a bond to be repaid by internal cash flows. In essence, duration measures price sensitivity to yield changes by measuring the approximate change of a security’s price that will result from a 100 basis point change in yield. Longer durations suggest greater sensitivity to changes in interest rates and vice versa. (For more, see: Advanced Bond Concepts: Duration.)
For instance, a bond carrying an effective duration of two years will rise 2% for every 1% drop in its yield, while the price of a bond with a five-year duration will rise 5% for every 1% increase in its yield. If interest rates are expected to fall, then duration is extended, and if interest rates are expected to rise, then duration is reduced. Low duration strategies are generally less volatile than long duration strategies. (For more, see: Understanding Interest Rates, Inflation and the Bond Market.)
Duration Doesn’t Always Work
Standard bond valuation formulas look at a simple set of criteria, including interest rates, yield, and duration to determine expected cash flows that can be discounted to present value. When looking at Treasury bonds, these dynamics are extremely predictable and work pretty well at approximating valuations, although raw economics can have an impact during a so-called “flight to safety.” (For more, see: Use Duration and Convexity to Measure Bond Risk.)
When analyzing other types of bonds, it’s not always appropriate to use duration as the only metric, particularly when referencing Treasury bonds. Treasury bonds may be effectively used as proxies during non-volatile times for investment-grade bonds, but these comparisons can fall apart during volatile periods (when they really matter), such as during the 2008 decline and again during the 2009 recovery.
Bond portfolio durations are also simply a weighted average of its underlying bonds, which have various weights and maturities. Consequently, the gain or loss predicted by analyzing duration will only be accurate if the market yields change the same amount for every bond across the maturity spectrum — a scenario that’s highly uncommon — which makes looking at the fine print of these funds very important. (For more, see: Investments with Low Interest Rate Risk and High Yields.)
Consider Other Risk Factors
Duration is certainly an important consideration when interest rates are expected to rise or fall, but there are many other risks that should also be carefully evaluated, including inflation risk, default risk, and call risk, among others. While some of these risks may not apply to U.S. government bonds — like default risk — corporate bonds and bond funds must be discounted to account for these risks. (For more, see: Interest Rates and Your Bond Investments.)
Bond funds also have a number of separate dynamics that should be carefully evaluated, such as risk concentration among individual bonds or bond types. In some cases, credit risk can be mitigated through diversification, but it doesn’t make these risks disappear entirely. Foreign exchange risks and other risks may apply to specialized funds that invest in foreign markets or exotic bonds.
For financial advisors, bond choices should look beyond yield to include safety as it applies to a client’s financial objectives. Bonds are often intended to be a safety net of sorts to hedge against a decline in equities, but the safety net may not be very effective if the bond portfolio consists of risky junk bond issues. In summary, it’s tempting to look at duration and yield, but there are many other important factors. (For more, see: Six Biggest Bond Risks.)
The Bottom Line
Duration can be useful for estimating the interest rate risks associated with bonds that are closely tracking Treasury bonds. When investors deviate too far from those bonds, the metric becomes far less useful at encompassing all of the different types of risks being measured. Financial advisors and their clients should then focus on a bond fund’s portfolio rather than relying on any single metric like duration. (For more, see: Is it Time to Buy Floating Rate Bonds?)