Many investors struggle to determine the appropriate amount of bond duration in an environment of rising interest rates.
The right amount of duration has to be considered in a portfolio context, because the main value of duration exposure comes through diversification.
Because of the negative correlation between duration and the returns of riskier assets, high-quality fixed income will still be a cornerstone of any disciplined portfolio.
We often hear investors say something like the following: “I own stocks for growth and bonds for income.” But in practice, of course, that is not how it really works. Investors hold portfolios for total return, but invest across asset classes for diversification. Diversification is still one of the most fascinating ideas of financial economics: a portfolio can have the same risk but higher total return, simply by investing in different markets. It is a free lunch.
This basic principle should guide decisions about an issue many investors are struggling with today: the appropriate amount of bond duration in an environment of rising interest rates. The U.S. recovery is on more stable footing, and the Federal Reserve looks to be gradually turning its attention away from pushing rates down and toward managing the monetary exit process. We therefore expect that yields will move higher over the next few years. For bonds themselves, the implications of this are straightforward: higher rates reduce prices and erode total returns. But what do rising rates mean in a portfolio context? What is the right amount of duration in a world with lower expected bond returns?
The answer, it turns out, relates to diversification. Since 1992, longer-term Treasury securities (7- to 10-year maturity) have delivered an annualized total return of 7.2%. Because of rising rates, we expect total returns for longer-term Treasuries to fall to around zero for the next 1-2 years. You can think of this as a downward shift in the distribution of returns—instead of a midpoint of 7.2%, the midpoint falls to zero (Exhibit 1 below). But the critical point to remember is that, in this example, only the midpoint is changing. Other aspects of Treasury returns—like their volatility and, most importantly, their correlations with other asset returns—need not change just because rates are rising. This means that Treasuries can still have diversification value—they can enhance portfolios’ risk-adjusted returns—even as rates rise.
Note: Benchmark interest rates and credit spreads often move in opposite directions, which will dull the impact of rising Treasury yields on corporate bonds and other spread sectors.
Consider a simple example in which an investor can only purchase two assets: an S&P 500 index and Treasuries with 7-10 years remaining maturity. What is the combination of these two assets that maximizes risk-adjusted returns? Basic portfolio theory tells us that we need to look at the distributions of the two assets—their returns, volatilities and correlation. Based on historical data (shown in the table below), we would have maximized risk-adjusted returns by investing 21% of the portfolio in the S&P 500 index and 79% of the portfolio in Treasuries. The portfolio would have had an annualized return of 7.5% and volatility of 5.4%—lower volatility than Treasuries with higher returns. Today a portfolio like this would have a duration of 6.2 years (calculated as the 79% Treasury share times its 7.78 year duration).
Past performance does not guarantee future results. It is not possible to invest directly into an index.
When interest rates are likely to rise and the distribution of expected Treasury returns shifts lower (as shown in Exhibit 1 above), the share of Treasuries in the portfolio should decline. But interestingly, even as expected returns fall to zero, an optimized portfolio would still hold some Treasuries. For example, if we think that Treasury returns will be zero, but their volatility and correlation with equity returns will stay the same, then the portfolio with the best risk-adjusted returns would invest 73% in the S&P 500 index and 27% in Treasuries. This portfolio would have a duration of 2.1 years. In other words, investors maximizing risk-adjusted returns still benefit from duration even if Treasuries themselves return zero.
More generally, we can show that the optimal duration of any portfolio will depend primarily on two factors: (1) the correlation between Treasury returns and the rest of the portfolio, and (2) the difference in total returns between Treasuries and the rest of the portfolio. These two factors could be considered measures of the benefits and costs of diversification, respectively. Exhibit 2 (below) graphs optimal durations for a portfolio of Treasuries and equities, where the other values are set to those in previous example. When expected Treasury returns fall, the optimal portfolio duration also falls. However, when correlations between Treasury and equity returns decline (become more negative), the optimal duration rises. At very low correlations expected Treasury returns matter very little (the lines are clustered closely together) because the benefits from diversification easily outweigh the costs. This means that it can be worth investing in Treasuries even if expected returns are negative—just like the insurance on your house, it can be worth paying up for things that pay off at the right time.
Therefore, the right amount of duration cannot be determined on a standalone basis. It has to be considered in a portfolio context, because the main value of duration exposure comes through diversification. With yields likely to rise, the cost of that diversification has increased, and portfolio duration should fall. However, because of the negative correlation between duration and the returns of riskier assets, high-quality fixed income will still be a cornerstone of any disciplined portfolio.
Diversification does not assure a profit or protect against loss.