Interest rates will rise at some point; investors must consider how to manage interest rate exposure in their portfolios.
Duration can be a highly misleading measure of interest rate risk when making comparisons across products.
For fixed income investors, sector exposure matters, and fundamental research can help avoid potholes.
It’s time for investors to start thinking seriously about interest rate risk in portfolios. Over the last three decades, long-term government bonds rewarded investors with healthy real returns, relatively low volatility and good performance during economic downturns. But at current yield levels, it is hard to escape the conclusion that prospective returns look much worse than the solid performance of recent history.
Long-term interest rates have declined for roughly 30 years but are bounded at zero. It is therefore natural to conclude that, at some point, the trend decline in rates will end and yields will revert back to a higher level. If something can’t go on forever, it won’t.
Measuring interest rate risk
Whatever an investor’s individual interest rate outlook, all investors must ultimately turn to the practical issue of how to manage interest rate exposure in their portfolios. This typically means a greater focus on duration — the most common measure of interest rate risk in fixed income. Unfortunately, duration can be a highly misleading measure of interest rate risk when making comparisons across products.
As a result, when comparing interest rate risk across fixed-income sectors, we prefer to use measures of “empirical” duration. The conventional measure of duration — which we will refer to as “analytical duration” — is grounded in the bond math of cash flows and discount rates. In contrast, empirical duration is based on the statistical relationship between benchmark interest rates and bond returns. It helps answer the practical question of what returns to expect if interest rates rise.
Exhibit 1 compares the average analytical duration of bond market sectors over the last 10 years to our estimate of their empirical duration. For empirical duration, the estimates are based on each sector’s price sensitivity to changes in the 10-year Treasury yield. By design, the empirical duration of 10-year Treasuries is nearly identical to the average analytical duration: if the 10-year Treasury rises by 100 basis points (bps), prices should be expected to fall by just over 8%, regardless of the measure we use.
Exhibit 1: Interest rate sensitivity differs across sectors (Jan 2003–Dec 2012)
Sources: Barclays, Credit Suisse and Columbia Management investment Advisers, LLC, December 2012
Past performance does not guarantee future results.
However, for all the other sectors the differences are quite significant. For example, investment-grade corporate bonds have an average analytical duration of over six years, but the actual sensitivity to changes in Treasury yields over the past decade has only been about half of that. High-yield corporate bonds and bank loans actually have negative empirical durations, meaning that they have historically posted higher returns during periods of rising Treasury yields. The very low or negative empirical durations highlight that investors are not primarily taking interest rate risk when allocating to these sectors – credit risk matters much more.
Positioning your bond portfolio
Given the prospect for rising rates, bond investing becomes a delicate exercise. While all bonds will not react the same way to rising Treasury yields, choosing between bonds of different maturities and sectors can have meaningful impact on prospective returns. As a result, it can be informative to see how different areas of the bond market have performed when Treasury rates have risen in the past.
In Exhibit 2, we illustrate these historical returns across sectors. While all sectors posted a positive median total return, most sectors did experience price losses in the mid-single digit range. However, there are some examples of sectors that have experienced price gains even while Treasury yields rose. Emerging market debt stands out as a strong performer in these environments as sovereign fundamentals in developing economies are less dependent on U.S. rates. Floating rate bank loans have also seen modest price gains, as interest in the asset class has tended to increase as investors flee longer duration assets in rising rate periods.
Exhibit 2: Rate rise impact on bond sectors. Median returns across sectors in periods when rates have risen (1992–2012)
Sources: Barclays, Merrill Lynch, JP Morgan, Credit Suisse, S&P, Columbia Management Investment Advisers, LLC
Measures median 12-month return during 44 periods over the past 20 years in which 10-year Treasury yields rose by at least 0.50% over 12-month period.
*Multi-sector benchmark = 35% U.S. Aggregate, 35% U.S. High Yield, 15% Emerging Market Bond, 15% Foreign Developed Market Bond
History demonstrates that bond market performance can have tremendous variance when yields begin to rise. Duration is a significant driver of return, given the price sensitivity of long maturity, fixed-rate issues. In addition, sector exposure matters, as idiosyncratic factors can cause performance of different parts of the bond market to diverge. Lastly, fundamental research can help investors avoid potholes. For example, it may seem that emerging market bonds are the best defense to rising Treasury rates, generating a median return of 14.6% during these historical periods. Keep in mind, however, that 14.6% is the median return, within a range of -19.8% to 37.7%. Therefore, investors should keep a diversified approach, focusing on bonds that offer enough yield (or risk premium) to compensate for potential price volatility.
For the full analysis, click here to read our white paper Navigating Rising Rates.
Risks include prepayments, foreign, political and economic developments and bond market fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop and vice versa. Lower quality debt securities involve greater risk of default or price volatility from changes in credit quality of individual issuers.
It is not possible to invest directly in any of the unmanaged indices listed below.
The Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury that have remaining maturities of more than one year.
The Standard & Poor’s 500 Index (S&P 500 Index) is an unmanaged list of common stocks that includes 500 large companies.
The Barclays U.S. Aggregate Index is an index comprising approximately 6,000 publicly traded bonds, including U.S. government, mortgage-backed, corporate and Yankee bonds with an average maturity of approximately 10 years. The index is weighted by the market value of the bonds included in the index. This index represents asset types that are subject to risk, including loss of principal.
Diversification does not assure a profit or protect against loss.
Duration — A measure of the sensitivity of the price of a fixed-income investment to a change in interest rates.
Correlation — In finance, a statistical measure of how two securities move in relation to each other.