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Effects of Duration in the Current Rate Environment

TOM BUTCHER: Why should investors be concerned about duration?

FRAN RODILOSSO: Investors should always be concerned about duration in a bond or in a portfolio of bonds. Measuring duration is how one measures a bond or bond portfolio’s sensitivity to movements in yield and movements in interest rates.

In today's environment, we're at unprecedentedly low yield levels, particularly in the U.S., Europe, and Japan. The market is anticipating that the Federal Open Market Committee (FOMC) is going to make a change in policy. The FOMC has stated its intention to begin hiking rates for the first time since late 2008. In the meantime, we've been stuck at a zero interest rate policy in terms of the federal funds rate target.

There are, however, many other factors to consider, especially when it comes to five-year yields, ten-year yields, or thirty-year yields. Those bond yields may not move in lockstep with how the Federal Reserve (Fed) moves the federal funds rate. In fact, the market shows us that the yield curve should be flattening. It has been flattening, which means the difference, for instance, between ten-year yields and two-year yields has narrowed in recent weeks. Ten-year Treasury yields and thirty-year Treasury yields, however, are far closer to the bottom ends of their ranges over the last five years than they are to the high ends. Since the “taper tantrum” of 2013, they've been even closer to the bottom ends of their ranges than to the high ends of their ranges. I think the market has thus already priced in low inflation expectations, expectations that commodity prices are not going to turn sharply higher, and expectations that tightness in labor markets, particularly in the U.S., is not going to become more extreme than it is now.

BUTCHER: Can you give me an example of what might happen should interest rates start rising?

RODILOSSO: Let’s consider a ten-year U.S. Treasury bond. Today the modified duration of the bond is about 8.8, which means if interest rates rise by 1%, one would expect the bond's price to fall by more than 8%. A ten-year Treasury has a current yield of about 2%. Let’s say in one year the yield on ten-years goes from 2% to 3%. The bond will lose about 8% in price. Actually, it will lose less than 8% in price because duration changes as yield increases. There might then be a 7.5% change in price and a 2% current yield. Over that period, however, total return is -5.5%, which represents a fairly significant loss for a risk-free bond investment. That is the mark-to-market effect if you sell those bonds.

If you own two-year Treasuries, which have a duration of about 1.9, and they go up a full percent higher over the next year, the total return will still be negative, but closer to net -1.5% because the duration on those two-years is much lower. That’s what it means to move down the curve, i.e., shorten your duration and achieve lower sensitivity to interest rates.

Should rates remain low or move even lower from here, however, there are other risks that investors should consider, such as reinvestment risk. If you are all short duration and have no interest rate risk, you'll constantly need to be reinvesting. If rates stay where they are or move higher, it will be good news. But if they're moving lower, you'll be investing at lower interest rates and that's not good news.

The other thing to remember is that duration is not the only risk of your bonds or your bond portfolio. There's credit risk. There's also political risk in emerging markets bonds. There's liquidity risk. Many factors can impact the price of your bonds, your bond fund, or your bond portfolio.

I think in the current context, regardless of whether you believe the Fed will proceed slowly or interest rates will rise rapidly, the risks are still skewed. There could be more damage done to your portfolio by higher rates. The market has priced in a less aggressive Fed and lower inflation expectations. Now is therefore a good time to consider your duration exposure and how you should manage it.

BUTCHER: Is the usefulness of duration measurements predicated on a parallel shift in the yield curve?

RODILOSSO: Duration does work as a measure when shifts are parallel, but it's still a fairly good relative risk measurement in any case. However, it has happened many times before in many different markets that short-term rates have risen as long-term rates have fallen. If that's the case now, looking at duration on your long-term bonds might cause you alarm if the Fed is hiking rates. It’s very important to think about where you are on the curve, i.e., where your exposure is, and how that part of the curve might be moving.

There are various scenarios that can play out over the next 12 months, regardless of whether the Fed starts hiking rates. Something to consider in terms of risks in the bond market is: the Fed has probably lost some credibility this year by not moving in September and by introducing the concept of, to use the Fed’s language, “concern about foreign markets.” A loss of credibility by the Fed could actually cause higher volatility and augment the risk of the U.S. Treasury market, which would ultimately lead to higher yields. If the market perceives that the Fed is behind the curve, i.e., not keeping up with inflationary expectations, the yield curve may steepen; five-year, ten-year, or thirty-year yields may rise much faster than the Fed moves short-term rates. That is not a scenario that anyone seems to be pricing in right now, which may be one small reason to consider it.

BUTCHER: Thank you very much.

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