Bond Fund Duration: An Art, Not a Science
Duration can provide guidance, but not certainty.
The 2008 financial crisis and the resulting market shocks had a number of surprising consequences. One that was particularly important to bond investors was the degree to which diversified bond funds struggled or lost money, even though investors the world over were scrambling into U.S. Treasuries. Take the long-term government and long-term bond Morningstar Categories. Most of the time, funds in these two groups are expected to have pretty similar risks—they both focus on bonds with long maturities and relatively high-quality debt. Yet the divergence in their 2008 performances was breathtaking: The average long-term government fund gained nearly 28%, while the average portfolio in the long-term bond category—funds that hold mostly nongovernment, but investment-grade bonds—fell by more than 3.7%. Why?
Bumping up Against the Limitations of Interest-Rate Duration
Under normal circumstances, most high-quality bond portfolios' effective durations would have provided guidance about how those funds would respond to Treasury market shifts. Funds in both categories have occupied a wide range of duration territory, but not enough to explain such a broad dispersion of returns. And if that weren't odd enough, a nearly inverse phenomenon occurred as the market snapped back from the financial crisis in 2009.
Clearly, this behavior wasn’t captured by the customary risk measure for Treasury funds. The primary reason is that duration—some have taken to calling it interest-rate duration—works best for bonds that are similar. Duration will normally provide an accurate picture when you're comparing prices on the same types of bonds. In other words, if you're using changes in Treasury bond yields as your reference, they're going to have the most predictive value for other Treasury bonds. And under normal circumstances, a typical duration calculation will also work pretty well for investment-grade corporate bonds whose yields aren't too far away from their comparable Treasury counterparts, say within 2 percentage points. Once you get much farther away than that, however, the measure begins to lose its predictive value as a gauge of how much movement your bonds will see relative to Treasuries.
Fortunately, we can estimate that kind of risk with a related measure called spread duration.
Spread Duration – Adding to the Toolkit
Instead of estimating how much a bond will gain or lose based on changes in Treasury yields, spread duration describes how much a bond's price is expected to move if there's a change in the gap between its yield and that of a comparable Treasury. If you were looking at a corporate bond with five years of spread duration, for example, that might not seem especially long given how we tend to view standard effective (or interest-rate) duration figures. If the company hit a particularly rough patch during otherwise normal times and its yield spread over Treasuries widened by 300 basis points (or 3%), the bond would be expected to lose 15%. Spreads on the overall Bloomberg Barclays Capital Investment Grade Corporate Bond Index widened to more than 640 basis points in December 2008, though, from around only 100 in February 2007. Assume that kind of spread widening—that is, in the neighborhood of 550 basis points—and the bond would have lost nearly twice that.
Use With Care
Regardless of what you're measuring, though, it's important to be mindful that duration, like almost any other measure, comes with important caveats.
1. Duration is an estimate. It's designed to help you gauge how much a bond's price is likely to rise or fall given a sudden change in market yields. Even under relatively "normal" conditions, though, a bond's price may not move exactly as its duration predicts.
2. Portfolio durations are just average. The duration of a fund portfolio consists of the weighted average of the durations of its underlying bonds. Those bonds usually have very different weights and maturities, so the gain or loss predicted by duration would be most accurate if market yields change by exactly the same amount for every bond along the maturity spectrum. Such a situation is rare, though. In fact it's possible for some rates to rise while others fall (a yield-curve twist). In that scenario, two different funds with the same average duration could perform very differently.
3. Even securities with the same durations can perform differently from one another. We’ve already seen that in the corporate bond example above. But there are factors that can affect other bonds too, especially those with embedded options, such as government-agency mortgages. The more complex a bond’s structure, in particular the presence of very flexible terms such as those giving a homeowner the option to refinance at any time, the more estimation and modeling is involved in arriving at a duration metric. In such cases, it’s quite possible that two asset managers would assign different duration estimates for the very same mortgage bond. Fortunately, we don’t usually see massive dispersion across portfolios as a result of that phenomenon, but it’s important to understand that there are usually modeling assumptions—and not just strict formulas—behind duration calculations.
4. Read the fine print. To understand your bond fund better, dig into its most recent portfolio report and try to figure out what it holds (or ask your financial advisor to do it for you). If you find things that you don't recognize, such interest-only mortgage CMOs or inverse-IOs, for example, look for a clear explanation in your fund's reports about how and why the fund is using them, or pick up the phone and call your fund company. We see them pop up in small amounts from time to time. But given how volatile those complex securities can be if short-term rates and/or prepayments shift notably, you'll want to make sure you're comfortable with your fund’s reasoning and risk controls, especially if they appear in concentrations of more than a few percentage points.
In short, duration—or interest-rate duration—can be a useful indicator for estimating the interest-rate risk of bonds that closely track the Treasury market. Any time you deviate from owning Treasuries, you usually get paid more yield and perhaps get a better longer-term total return (perhaps). But you assume more and different risks, and tracking them all becomes more complicated. It therefore makes sense to use duration with some caution—and to make the effort to know what's in a fund's portfolio, rather than relying on duration or any other single number or grade when evaluating its suitability for your portfolio.
A version of this column was published in April 2013.