Duration: More Than Meets the Eye

Duration is a key bond metric to watch as rates change. Duration is a term that comes up often in discussions of bond portfolio management, especially when major shifts are happening on the yield curve. A bond’s or bond portfolio’s duration expresses its exposure to interest rate risk, with higher duration signaling greater sensitivity to interest rate changes. In an environment when interest rates are rising, lowering duration in a bond portfolio can be an effective way of managing the risk of declining values (Remember, in general, bond prices fall when interest rates rise). But there’s more to understanding duration than this headline number. There are different ways bond managers can get to a specific duration target. For instance, a diversified portfolio of very short- and long-term bonds (a barbell approach) could arrive at an effective duration of 2 years, but so could a non-diverse portfolio comprised entirely of 2-year bonds. Interest rate changes would affect each portfolio differently, even though duration is the same for both.  The composition of duration is important to know when assessing the potential return and risks of a bond investment, especially in an environment where short-term rates are likely to rise. Where duration is coming from—meaning, where the bond portfolio is exposed across its benchmark yield curve—can play a critical role in determining a bond fund’s potential return. 

Duration in the real world

One limitation of relying solely on effective duration is that it only applies when interest rates move in lock step. In other words, when 2-year and 10-year rates rise or fall by the same amount at the same time. As a result, the new yield curve would be parallel to the previous curve.  Obviously, bonds and interest rates don’t work like that. Yields on longer-term bonds may swing more or less than shorter-term bonds, and sometimes not even in the same direction.  We witnessed these different yield curve moves in the Treasury market this year alone.  

Changes in yield vary across the curve

Source: FactSet, 12/31/2020 – 12/17/2021 Past performance is no guarantee of future results, which will vary.

Key rate duration measures the duration at specific points (key rates) along the yield curve. It offers a more nuanced look at a bond portfolio’s interest rate risk exposure, because it can help estimate changes in bond values when rates change differently along the yield curve.  By seeing how different bonds performed under more varied conditions—a more realistic view of actual bond market movement—a fund manager can allocate to the bond maturities to help meet investment objectives.  When looking at a bond portfolio, one needs to evaluate the duration distribution and not just the headline number.   This will help you assess how interest rate changes at different parts of the yield curve may affect the portfolio’s NAV.

Flexibility is key

In the months ahead the market is expecting the Fed to end accommodative monetary policies, first by winding down asset purchases before eventually raising rates.  When the Fed has raised rates in the past, going back as far as the mid-to-late 80s, we have seen the yield curve flatten, especially in mid-range maturities between 2- and 10-years. With history as a guide, we believe we have the potential to see a similar shift as the Fed starts the next rate-raising cycle.  

In previous Federal Reserve rate hike cycles, the yield curve has flattened.