Basic Duration Rule
As the Federal Reserve signals interest rate cuts, understanding how bond durations and yield curves interact becomes crucial. Duration is a key measure that helps investors estimate their bond portfolios' sensitivity to interest rate changes. Anticipating how different fixed income strategies will respond to these changes enables investors to make more informed decisions regarding their portfolios.
The rule of thumb regarding duration is this: multiplying a bond’s duration by a change in rates equals the price change percentage. A portfolio with a duration of five years should decline in value by 5% upon a 100-basis point (bp) (or 1%) increase in rates. When explaining this quick and easy calculation, the math is often followed by two caveats — 1) for small changes in rates and 2) assuming an instantaneous parallel shift in the yield curve. It is the second caveat that may go from often ignored assumption to frequently cited financial theory when Fed rate cuts commence.
Yield Curve Dynamics and Fed Policy
The 2-year U.S. Treasury yield and fed funds rate have historically moved in line with each other. So it is reasonable to expect rates on the front end of the Treasury curve to fall as the Fed cuts the fed funds target rate. More recently, the 2-year Treasury yield has already begun falling, in anticipation of Fed rate cuts. Once the Fed does start cutting, the 2-year Treasury may not move much initially, allowing policy to catch up to it. Yields further out on the curve are less dependent upon Fed policy, and it is likely they will not move in tandem with the 2-year Treasury, causing a shift in the shape of the yield curve.
Figure 1: Fed Funds Target and 2-Year Treasury Are Highly Correlated
Source: FactSet, as of 8/16/24. Past performance does not indicate future results. Treasury Securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity. Interest income on these securities is exempt from state and local taxes.
Knowing that different parts of the rate curve may respond differently to rate cuts, what does this mean for the predictive power of duration?
This is where key rate duration comes in. Key rate duration takes duration a step further and breaks down a portfolio by its cash flows in order to determine rate sensitivity at different points (or key rates) on the yield curve. For example, a portfolio of bonds with five-year maturities and a duration of 3.0 will not be impacted if the 10-year Treasury falls by 50 bps (and all other rates remain unchanged). The bonds don’t have a 10-year cash flow. On the other hand, this same portfolio will be more sensitive to changes in the 5-year Treasury yield than the 2-year Treasury because most of the portfolio’s cash flows occur in five years. Key rate duration allows investors to more precisely analyze a portfolio’s rate sensitivity by deconstructing a portfolio duration into its components – the duration at each point along the yield curve. Key rate duration can also be thought of as contribution to duration. The sum of key rate durations is equal to portfolio duration.
Below are the key rate durations for the ICE BofA US Corporate Index. The duration is 6.7 and most of the index’s sensitivity is at the 10-year key rate. Intuitively, moves in the 2-year Treasury are going to be less impactful than moves in the 10-year Treasury.
Figure 2: Key Rate Duration Better Explains Rate Sensitivity Across the Yield Curve
Source: FactSet. Key Rate Durations for ICE BofA US Corporate Index as of 8/15/24. It is not possible to invest in an index. Past performance does not indicate future results.
Illustrating Yield Curve Shifts
The chart below is an illustrative look at yield curve shifts. On the left, there is an instantaneous parallel shift in which rates across the curve decline by 100 bps. Assuming that investment grade spreads remain unchanged, the duration formula says the corporate bond index would appreciate 6.7%. The chart on the right may be a more realistic depiction of a rate curve move — in this case, the front end declines to a greater extent than the belly and long end of the curve. This chart shows a 150-bp decline in the 2-year but only 50 bps in the 5-year and 25 bps in the 10-year. Incorrectly applying the duration formula to the rate decline in the front end would result in the expectation of a 10% price increase. Instead of multiplying 6.7 by 1.5, multiplying each key rate duration by the change in that rate comes up with a much more accurate measure of 2.75%. Since this index is most sensitive to the 10-year key rate, and there was only a small move at that part of the yield curve, the overall price impact from the rate move was much more muted.
Figure 3: Applying Key Rate Durations to Non-Parallel Shifts Provide More Accurate Return Estimates
Parallel Shift in Yield Curve
Steepening Yield Curve
Source: FactSet. For Illustrative Purposes Only. Past performance does not indicate future results.
Yield Curve Steepness Matters
Another part of that parallel shift assumption is the word “instantaneous”. It is only one word, but it matters because the approximation doesn’t take into account income or time, both of which affect bond returns in practice. Time matters because a bond’s price is dependent on time to maturity as well as yield to maturity. A bond trading at a discount is going to increase in price as both of those factors decrease.
The chart below is an illustration of an upward sloping credit yield curve. Assume an investor can buy bonds at any point along the curve. The curve is considerably steeper in the front end. If the yield curve looks the same in a year’s time, the 3-year bond with a yield of 6.0% becomes a 2-year bond, and at that point will have a higher price because it is now based on the much lower 2-year yield of 5.3%. This is called “rolling down the curve” because the bond’s price is appreciating as time passes, and it moves to shorter points along the curve with lower yields. If the 9-year maturity on the curve is flat to the 10-year, investing in the 10-year bond would have returned 6.5% over the year. However, the 3-year bond returned 7.4% over the same period, even though its yield to maturity was only 6.0%, because it benefited from a steep yield curve.
Figure 4: Enhancing Return Potential by Rolling Down the Yield Curve
Source: FactSet. For Illustrative Purposes Only. Past performance does not indicate future results.
Strategic Considerations for Rate Cuts
By better understanding the composition of portfolios and how to apply duration calculations to them, investors can make more informed decisions regarding positioning for rate cuts. The sentiment of “longer duration means better performance when the Fed cuts” is flawed. A shifting yield curve creates new opportunities to benefit from steepness. Different investment strategies have varying sensitivities to points along the yield curve. If an investor believes the 3-7-year part of the curve will decline more than the long end, investing in long-duration bonds may not be the best way to implement that view. A portfolio with more key rate duration in that part of the curve may be a more appropriate strategy. The conventional wisdom of using duration to calculate the impact of rates on bond prices is certainly a useful tool, but understanding its limitations and how to correct for them may go a long way for fixed-income investors.
Definitions:
ICE BofA US Corporate Index tracks the performance of US dollar denominated investment grade rated corporate debt publicly issued in the US domestic market.
Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. Duration is a measure of sensitivity of a bond's or fixed-income portfolio's price to changes in interest rates.
About Risk
All investments are subject to market risk and will fluctuate in value.
Investing in below-investment-grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. High yield securities (junk bonds) have speculative characteristics and present a greater risk of loss than higher-quality debt securities. These securities can also be subject to greater price volatility.
Bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.
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