Portfolio Duration Doesn't Tell the Whole Story
Investors looking to gauge a fund's interest-rate sensitivity need to look past duration.
Investors looking to gauge a fund's interest-rate sensitivity need to look past duration.
The inverse relationship between bond prices and interest rates is a central tenet of bond math. As rates rise, new, higher-coupon bonds become more attractive than previously issued lower-coupon bonds. To entice investors to buy those lower-coupon bonds, prices must fall. Eventually, higher bond yields will be good for investors, but the short-term pain hits investors where it hurts: lower investment returns because of the drop in bond price.
Experienced bond investors may look at a fund's duration (a measure of price sensitivity owing to changes in interest rates) to determine whether a portfolio is "protected" from rising rates. Duration, however, has several shortcomings. It's a good measure of interest-rate risk for noncallable U.S. Treasury bonds, but it becomes less predictive for funds with more credit risk, such as junk bonds, or those with unpredictable cash flows, such as mortgage-backed securities.
In addition, portfolio duration measures assume a parallel shift in the yield curve, or that all rates along the entire yield curve (one month to 30 years) move up or down by the exact same amount. This is almost never the case in the real world.
My colleague, Eric Jacobson, discussed this phenomenon in a previous Fund Spy titled, "What History Tells Us About the Importance of a Fed Rate Hike." Eric looked back at previous rate hike cycles to show that the yield curve acts very differently depending largely on the economic environment, among other factors, during each rate cycle.
Portfolio duration is a complex topic, but a simple example can illustrate the concept. Assume three zero-coupon Treasury bonds with maturities of six months, two years, and 10 years, held by funds A and B, but in different combinations, each of which will produce an overall average duration of two years. Fund A, for example, allocates 100% of its assets to the two-year bond. By contrast, Fund B owns a mix of six-month and 10-year bonds (roughly 84% and 16%, respectively). Using market rates from Dec. 31, 2016, the tables below show the bonds' prices and implied yields. Because these are zero-coupon bonds, each bond's duration is the same as its maturity.
Nevertheless, it's important to have a handle on what duration can and cannot reveal about a fund's potential behavior. Understanding that the changing shape of the yield curve can affect a fund's value in a meaningful way can allow investors to create more-realistic expectations around returns.
A previous version of this article, by Cara Esser, CFA, was published in February 2016.
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