Duration is the mother of all risk metrics in bond investing

by | Feb 16, 2024

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Written by Jayadev Mishra, senior portfolio manager of the Global High Yield Fund at J.Safra Sarasin Sustainable Asset Management

What is duration, and how does it impact someone’s fixed income investments in practice?

Duration is the mother of all risk metrics in bond investing, but it is also a source of return in active portfolio management. It measures the sensitivity of the price of a fixed-income investment, such as a bond, to changes in interest rates. It helps investors understand how much the price of a bond is likely to change in response to changes in interest rates.

Technically speaking, duration is the weighted average of the time it takes for a bond’s cash flows to be paid. It considers both the timing and amount of future cash flows, including coupon payments and the return of principal at maturity. More intuitively, the duration of a bond is used to estimate how much the bond’s price will change for a 1% change in yield. A longer duration indicates higher interest rate sensitivity, meaning the bond’s price is more likely to change significantly in response to interest rate movements.

 
 

Investors can use duration to manage interest rate risk in their fixed-income portfolios. For instance, by matching the duration of a bond or a portfolio to the investor’s time horizon or risk tolerance, they can better control the impact of interest rate movements

What are the risks of a high yield portfolio with high duration? What are the potential advantages?

High yield bonds, like any other fixed income instrument, are subject to interest rates risk and therefore duration is also an important risk factor when investing in high yield bonds. 

 

Obviously, high yield bonds or portfolios with longer duration will be subject to higher interest rate risk, thus suffering amplified performance erosion in the event of a large increase in the yield. However, high yield bond indices tend to have a shorter duration than higher rated bond indices. This is explained by generally shorter maturity and higher coupon payments, which mitigate the duration effect as the weighted average of the time to full repayment will be shorter. 

The main advantage of investing in high yield bonds with an average or longer duration is the yield curve roll down effect. In normal market conditions yield curves are upward sloping and there is a term premium for longer maturities. Such bonds deliver returns in excess of the original coupon as their yield tends to decline with time. Moderate upward movements in interest rates are usually compensated by the higher the credit spread offered by bonds with long duration. 

What are the risks of a high yield portfolio with low duration? What are the potential advantages?

Just the converse of the previous question. Assuming credit risk is similar in both the portfolios, a shorter duration portfolio would tend to be less affected by a sharp rise in expected yields (interest rate and credit spreads).

Is there a certain type of investor more suited to a high yield portfolio with higher duration? 

Credit risk and duration are both key return drivers for fixed income products. Choosing higher or lower credit or duration risk alters the risk-return profile of products. An investor really wary of an imminent significant rise in interest rates is perhaps better placed with a short duration product. However, they would give up on a significant amount of carry and potential tightening in case interest rates stay stable or tighten. A return seeking investor thinking of high yield investments should seek adequate duration exposure.

Investors such as family offices, pension funds or insurance companies, who have longer investment horizons and can withstand short-term fluctuations may benefit from the potentially higher returns offered by longer-duration high-yield bonds.

Is there a certain type of investor more suited to a high yield portfolio with lower duration?

With an assumption that a high yield investor is comfortable with associated credit risk, a lower duration portfolio would be suitable for an investor expecting an imminent and significant rise in interest rates. Both of these conditions are necessary since, if the rise in interest rates is delayed or only moderate, the investor would have benefitted from the carry and roll down effects discussed above.

Why is now a particularly important time to look at duration?

Changes in monetary policies, such as interest rate hikes or cuts by central banks, can impact the entire fixed-income market. Investors need to assess their portfolios’ sensitivity to these policy changes, and duration is a key metric for this analysis. In an environment where interest rates are expected to change, either rising or falling, the impact on bond prices can be significant. Duration helps investors assess how sensitive their bond portfolios are to interest rate movements. With pivot discussions on both sides of the Atlantic, now is a crucial time to keep an eye on Duration.

What should advisers think about when deciding the duration of their clients bond portfolio?

Financial advisers play a crucial role in helping clients make informed decisions about their bond portfolios, and determining the appropriate duration is a key aspect of this process as duration can amplify the effect of changes in interest rates or credit risk premium. When advisers are deciding on the duration of their clients’ bond portfolios, they should find the right balance between the investor’s return aspiration and the risk tolerance.

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