Duration is a measure of bond price sensitivity to changes in interest rates, and it’s a risk every bond investor is exposed to.
That risk tends to be more pronounced with longer duration, because the longer the duration the more sensitive a bond’s price is to changes in interest rates.
“For the last several decades interest rates have fallen so investors have benefitted the most from owning longer duration securities,” says Brian Carney, portfolio manager with Canso Investment Counsel Ltd.
“As central banks raise interest rates, fixed income markets are experiencing substantial losses with longer duration portfolios experiencing the most pain.
We don’t believe investors are being compensated for the risk of owning long duration credit” in this market.
Why is duration important?
A longer Macaulay duration means the bond or fixed income portfolio is more sensitive to changes in interest rates. The duration of your bond investments, be they individual bonds or a bond fund, will impact the overall return you get.
For example, the price of a 2-year Government of Canada bond with a duration of 1.9 years will change around 1.9% for each 1% move in its yield. By comparison, a 30-year Government of Canada bond with a duration of 20.5 years will change 20.5% in price for that same 1% change in interest rates.
Being long duration could prove very costly when interest rates are rising, given that bond prices move in the opposite direction of interest rates because of the inverse relationship between the two.
Short or long?
It depends. That’s because duration is sometimes your friend — and sometimes it’s not.
Over the last four decades as interest rates trended lower, investors were rewarded with higher returns for owning longer duration bonds. Over the last 18 months, rising interest rates highlighted the risk in fixed income securities, most notably longer duration bonds.
In 2022, with central banks raising overnight rates and bond yields already substantially higher bond managers are faced with a tough choice. Is the move higher in interest rates close to the finish line or only just starting. How a manager answers that question will determine how much, or how little, duration risk to take in their portfolio.
Top-down portfolio management
To decide whether to go long or short duration, some portfolio managers make “top down” calls on sectors, credit quality, and duration based on their macro or big picture economic views, including GDP and inflation expectations. They set a duration target or duration range, which is often that of a benchmark fixed income index plus or minus a set number of years.
Duration management entails investing in bonds with specific durations, based on the outlook for interest rates. If a manager expects interest rates to fall, they will invest in longer duration bonds; if they expect interest rates to rise, they’ll go shorter.
Bottom-up portfolio management
Other portfolio managers are bottom-up, fundamental managers who analyze individual companies, not markets or trends, and invest in specific bonds based on the risk profile of the issuer and risk versus potential reward for each bond. Duration is simply the result of the buy and sell decisions — without any duration targeting.
This type of manager is more focused on ensuring investors are being adequately compensated for the risk of owning bonds — of any duration.
Consider the risks
Carney assesses the current duration risk relative to historical norms as being a 7 out of 10 – lower than you may expect given the gloomy financial press headlines.
“We’ve seen such a dramatic upward move in yields over the last 15 months already,” says Carney.
“As an example, 30-year Government of Canada bonds yield 3.0% today, versus 1.2% at the start of 2021” – which is a huge move in the bond market.
Looking ahead
Heading into the second half of 2022, bond investors find themselves in uncertain and unfamiliar territory. Interest rates are rising and bonds have sold off considerably, generating negative returns. That said yields are now at levels that may encourage existing fixed income investors to stand put, or entice others back to the bond market.
For fixed income investors the easy return days of the last several decades are over. Buy-and-hold strategies worked well when the bond market was in a secular bull phase, but are likely to perform poorly as the favourable tailwinds of disinflation and falling rates are now the headwinds of higher inflation and rising rates.
Extracting positive returns in fixed income has become much more challenging. In this uncertain environment investors should evaluate the benefits of passive strategies tied to a specific duration target versus active managers who can mitigate duration risk.
DISCLAIMER
The views and information expressed in this publication are for informational purposes only. Information in this publication is not intended to constitute legal, tax, securities or investment advice and is made available on an “as is” basis. Information in this presentation is subject to change without notice and Canso Investment Counsel Ltd. does not assume any duty to update any information herein. Certain information in this publication has been derived or obtained from sources believed to be trustworthy and/or reliable. Canso Investment Counsel Ltd. does not assume responsibility for the accuracy, currency, reliability or correctness of any such information.
