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As the Federal Reserve winds down its quantitative easing program, or QE, investor concerns about rising rates are forcing them to reconsider duration within their bond portfolios. Matt Tucker describes the concept of duration and takes a look at various duration strategies.

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A major fixed income strategy in 2013 was duration rotation, investors reducing the interest rate risk of their portfolios. As the term “duration” becomes increasingly prevalent in our conversations on The Blog and elsewhere, I thought it would be good to explain this concept.

What is Duration?

Duration measures the sensitivity of a bond’s price to changes in interest rates. The higher the duration, the higher the interest rate risk. To get a better sense of what this means lets use as an example a five year maturity bond that pays a 3% coupon rate. Let’s say that you buy this bond today at a price of $100. Tomorrow interest rates rise up to 4%. In this new market you could buy a five year maturity bond with a 4% coupon for $100. Given that you can now get a 4% bond for $100, it seems likely that the 3% bond that you bought yesterday isn’t worth as much as it was. After all, no one is going to be willing to pay $100 for it if they can get a 4% bond instead. So how much value did your 3% bond lose? You can calculate it by using the duration of the bond, the duration measures how much a bond’s price moves in response to changes in interest rates. In this case the duration of your 3% bond is going to be around four, and it will fall in price to around $96 when interest rates rise. Notice that when interest rates went up the price of the bond went down. This is a fundamental property of the fixed income market, bond prices and interest rates move in opposite directions.

Investors showed a particular sensitivity to interest rate risk in May 2013, when the Federal Reserve hinted that it would wind down its easy money program. Interest rates spiked in the months that followed, and as a result the prices of bonds and bond funds fell. Concerned investors pursued lower duration strategies in order to reduce the interest rate risk in their portfolios. The trend continued through the end of the year, with ETF flows shifting to short duration funds to the tune of $35.9 billion.

Fixed Income Short Duration

Source: BlackRock

A Closer Look: Short, Medium and Long Duration

Now that we have the duration concept down, let’s take a look at some actual ETFs to get a sense of their durations and performance. When we say short duration, we are generally referring to bonds that mature within three years. A short duration strategy tends to have lower yield than a long duration fund, but in a rising interest rate environment a short duration fund will experience less price loss. An example of a short duration fund is the iShares 1-3 Year Treasury Bond ETF (NYSEARCA:SHY), it has a duration of 1.84 years. Given this low level of duration, SHY held up fairly well in 2013, returning 0.23%.

Intermediate duration funds generally hold bonds that mature within 3 to 10 years. Yield is higher than with short duration funds, while interest rate risk is lower than long duration. An example of an intermediate duration fund is the iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF). This fund has a duration of 7.53 years, and as a result returned -6.12% in 2013 as it was more impacted by rising rates than SHY was.

Long duration bond funds generally have a maturity of more than 10 years, and usually offer the highest interest rates, making them the optimal choice in a falling rate environment. However, in a rising rate environment long duration funds can experience sharp price declines. An example of a long duration fund is the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT). This fund has a duration of 16.38 years, and as a result returned -13.91% in 2013. As you can see, during a period of large interest rate movements, the duration of a bond investment will often drive its performance.

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A Duration Strategy for 2014

As my colleague Russ Koesterich highlighted in the recent Investment Directions, we expect intermediate interest rates to continue to rise during 2014. This makes intermediate duration funds likely less attractive than shorter duration funds.

Source: Why Duration Matters