Using Bond Fund Duration Is an Art, Not a Science
The metric can provide guidance, but not certainty.
Interest-rate risk is top of mind these days given that bond yields have risen across the board thus far in 2018. The 10-year Treasury yield hovered at 2.94% on Sept. 7, up from 2.4% at the end of last year, and the Bloomberg Barclays U.S. Aggregate Bond Index has fallen 1.4% for the year thus far. Looking at duration is a key first step in understanding that dynamic.
One problem with duration is that it doesn't--and can't--always provide the answers investors expect from it. The 2008 financial crisis and the resulting market shocks provided a very stark illustration of the issue. Most diversified bond funds struggled or lost money during the crisis, even though they carried plenty of duration at a time when investors the world over were scrambling into U.S. Treasuries, pushing their yields down more sharply than they had moved in years; their prices skyrocketed.
The long-term government and long-term bond Morningstar Categories made for a painful contrast. Usually they behave similarly, as both focus on bonds with long maturities and high-quality debt. Yet the divergence in their 2008 performance 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 Duration
Under normal circumstances, most high-quality bond portfolios' effective durations would have provided useful guidance about how those funds would respond to Treasury market shifts during the crisis. Funds in both the long-term government and long-term bond categories 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 crisis in 2009.
Clearly, this behavior wasn't captured by the go-to risk metric of duration. The primary reason is that duration works best for bonds that are similar, and it will normally provide an accurate picture when 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 work pretty well for investment-grade corporate bonds with yields that aren't too far away from their comparable Treasury counterparts--say, within 2 percentage points. Much farther away than that, however, and the measure begins to lose its value as a gauge of how much movement your bonds will see relative to Treasuries. In fact, in order to be explicit about that, many portfolio managers now specify that they're talking about interest-rate, Treasury, or even "hard" duration, and that those metrics won't be as predictive when it comes to the risk that other bonds won't act like Treasuries. Fortunately, there is a tool to help managers understand the risks associated with non-Treasury bonds.
Spread Duration – Adding to the Tool Kit
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.
Unfortunately, most fund companies don't report spread duration broadly or include it on their websites for individual investors. If you're anxious to know how much spread duration risk is lurking in your fund, though, it's worth calling to ask.
Use With Care
Regardless of what you're measuring, though, it's important to be mindful that duration, like almost any other measure, is not a panacea.
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. But you assume more and different risks, and tracking them all becomes more complicated. It therefore makes sense to use duration with 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.