June 3, 2016
When Low Duration Changes
By Betsy C. Shelton, Director of Research,
Senior Portfolio Manager
In anticipation of a rising interest environment, much attention has been focused on what should be the duration of one’s portfolio. It has been my experience that this term has been so bandied about by both the media and market professionals that investors often get a malformed opinion of the true purpose and impact of this risk management tool.
Since its creation in 1938, duration has morphed into a variety of calculations, depending upon what factors are used. It is a weighty subject on which numerous articles and books have been written. Space constraints clearly do not allow for us to go into detail here. Suffice it to say, effective duration is the calculation most often used for bonds with early redemption (call) features. Because municipal bonds routinely have call features not readily found in other fixed income classes, we felt it important to revisit just how duration is applied and its effects on the outcome on a desired portfolio strategy. More specifically, focusing on duration, either alone or in a disproportionate way, often offers a distorted view of where a portfolio in general or an individual security actually stands in relationship to the actual market risk exposure.
Simply stated, duration risk is most commonly defined as the sensitivity of a bond’s price to a one percent change in interest rates. Although stated in years, duration is more succinctly a statement of the time component characteristically used to measure just how long it will take for an investor to recoup his or her investment. It does not, however, create a new or specific maturity date for the bond but rather instead shows a projection of the probable life of that holding. It is a dynamic figure that signals the anticipated degree of price fluctuation in response to the up or down movement of interest rates. Important variables such as the maturity date, coupon rate, market yield, and call features all play significant roles in the duration computation. The higher the duration figure, the more sensitive the investment will be to any rate changes (think volatility). Keep in mind that the duration measurement assumes a parallel shift in the yield curve; that is all maturities will experience the same amount of basis point change and direction across the entire bond spectrum. Due to the non-linear nature of a normal yield curve such an event rarely, if ever, occurs. Duration further assumes that all interest payments will be reinvested at the investor’s acquisition yield, a fact that is virtually impossible to achieve over the long run.
The use of duration as a portfolio management tool is much more effective in other fixed income assets classes where the majority of bonds are non-callable. However, for those issues that do have an embedded call the empirical nature of the effective duration formula predicts that a bond will be called based solely on the then current level of interest rates. No longer are coupon, maturity and yield the sole drivers of duration. Now the call feature becomes the more dominate factor in determining the repayment term and associated volatility exposure (See chart below).
Source – Investopedia
So what does this discussion have to do with municipal bonds? Unfortunately quite a lot. Why? Because many mutual funds, ETFs and large money managers hold long-dated municipal bonds with short calls. It is often contended that these holdings, due to their short durations, will provide the equivalent or possibly even better returns than can be offered by owning short or intermediate maturity bonds. How is this possible? The answer lies in the fact that since the effective duration formula treats all callable bonds with above market rate coupons as if they will unequivocally be called, a large percentage of long-dated bonds in these portfolios will subsequently exhibit low duration rates (think blue quadrant). The caveat is that this is true, at least for the moment. But what happens when rates begin to rise? These same bonds will likely no longer be priced to their short calls. Now instead the bonds will more than likely be priced to maturity, effectively moving their durations into the lower yellow quadrant or possibly even into the upper red one. In other words, the long-dated bond has now gone from being a short (2 to 3 years) or intermediate bond (5 to 8 years) depending upon the applicable call dates, to a long bond (30 years plus). The impact of any meaningful move in interest rates is can be sizable. A 50 basis point or even only a 25 basis point move in rates affects the dollar price of a 5-year bonds significantly less than it does the price of a callable 30-year bond. This is often a rude awakening to the investor who believes he was being prudent buying a low duration asset but failed to investigate the other characteristics of the bond or portfolio overall. Even for those investors willing to take on more risk for a higher rate of return, a dependence on duration as the supreme factor can often provide a false sense of security. So how can an investor uncover what their real vulnerability is? One clue is to look at both the average final maturity and the final maturity dates of the aggregate holdings. The greater the difference between either of these and the overall duration rate, the more likely the portfolio holds long-dated bonds which are currently being priced to a much shorter call date. As previously noted, when rates rise these issues will be increasingly more susceptible to price declines that will result in a significant extension of duration.
The use of the term “duration” or “duration rate” has become so ubiquitous in most marketing materials that it has created the fallacy that it can be universally and effectively applied to all asset classes. Touting returns based on duration without regard to the intrinsic characteristic differences among these classes can be dangerous. Combine this tendency with the formula’s unrealistic assumptions of tandem rate movement and constant reinvestment rate and the outcome is the illusion of a maturity structure that essentially is not there. So much emphasis has been placed on duration that many think it is a surrogate for maturity, when it is not. Unlike a maturity which is fixed in time, duration can and often does “jump up” to the surprise of unsuspecting investors who have been lulled into thinking that they had limited their interest rate exposure when in truth they have done just the opposite. Suddenly these investors find they have a much longer portfolio than if they had embraced the more conservative strategy of employing a more balanced maturity distribution. (We invite you to read this month’s Letter from the Chairman which discusses how to take advantage of rising interest rates rather than falling victim to them.)
CFI does not consider the accuracy of duration to be the ultimate determinant when deciding how and where to position our clients’ portfolios. There are numerous reasons why a particular municipal security may or may not be called far beyond just the mere presence of a call feature. A mathematical formula spewed out by a computer quite frankly cannot take the place of doing the homework needed to determine the likely possibility of an issuer exercising their call rights. Digging deep into the issuance history, investigating “sector quirks”, and monitoring the prior actions of the issuer are just a few of the tasks required in order to assess the likelihood of a call.
In closing, let me reiterate that duration needs to be viewed as just one of the many tools in the portfolio management toolbox. Its value lies in revealing interest rate sensitivities, not as a replacement for the proper maturity construction of a portfolio. Nor does it replace the need to assess other fixed income risks, be they credit, liquidity, political or headline, which, like duration risk, serve to influence the vulnerability of one’s portfolio. Our concern arises over what appears to be a trend where investors have naively assumed that since the duration of a security or overall portfolio is short, it is equivalent to owning short bonds. In truth they have unwittingly incurred much greater exposure to market risks than intended or is suitable. Far too many people have let the erosion of yields experienced over the last five years dictate a riskier investment strategy. Many of these investors could soon come to regret their reliance on “short duration” as the proxy for a more defensive approach consistent with their risk tolerance level. Only time will tell if our concerns prove valid.
The contents herein are for informational purposes only, and under no circumstances are they to be construed as a recommendation of a solicitation. The information and opinions herein are subject to change without notice and CFI does not undertake to advise the reader of changes in opinion or information.
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