Rising U.S. interest rates in recent months have propelled this often-cited bond risk statistic back into the spotlight. Fixed-income investors should take note. Knowing the duration of your bond funds can help you gauge how their performance is likely to be affected should interest rates continue to rise in the year ahead.
Bond duration explained
Duration measures how much a bond’s price is likely to change given a corresponding change in interest rates. The connection has to do with the relationship between bond prices and interest rates. Generally, when interest rates rise, prices of existing bonds fall. For example, if rates rise to 4% for 10-year U.S. Treasury bonds, then existing 10-year Treasury bonds paying 3% interest become less attractive. Of course, the reverse is also true: If rates are falling, then existing bonds with higher rates become more attractive.
Duration is a way of gauging how sensitive your bond or bond fund is to changes in rates. The metric is measured in years. Essentially, for every 1% change in interest rates, a bond’s price will change in the opposite direction by 1% for every year of duration. A bond with a duration of five years will be more sensitive to changes in interest rates than a bond with a duration of three years. This sensitivity is also commonly known as interest-rate risk.
Why duration matters now
Interest rates are beginning to rise in earnest after many years of being pinned to the floor by central bank policy and a lack of inflation. Last year, the U.S. Federal Reserve (Fed) raised short-term rates three times in response to stronger economic growth, and the Fed has signaled its intention to raise rates an additional two to three times in 2018 as well.1 At the same time, longer-term rates, which are driven by market sentiment, have also started to creep up as investors anticipate rising levels of inflation in our expanding economy. The 10-year U.S. Treasury bond yield started the year at 2.41% and as of early February, had already surpassed 2.80%.2 Today’s rising bond yields will likely represent the start of greater bond market volatility in the year ahead.
The good news is that duration varies widely across different types of bonds. For example, at the start of 2018, the government-bond-heavy Bloomberg Barclays Global Aggregate Bond Index had a duration of 7.82 years, while the Bloomberg Barclays U.S. High Yield Index had a duration of only 3.87 years. In bonds, as in life, nothing comes for free. The shorter duration on high-yield bonds comes with a different kind of risk that government bonds don’t have, which is credit risk—the risk of a bond issuer defaulting on its bond obligations.
Bond mutual fund managers actively adjust the overall duration of a portfolio by mixing different kinds of bonds and different maturities. According to Morningstar, the category average duration for multisector bond funds was 3.36 years, while nontraditional bond funds, as of December 31, 2017, had an average duration of just 1.63 years. Managers of funds with the ability to invest overseas can also take advantage of the fact that rates seldom move in lockstep from one country to the next—they sometimes even move in opposite directions.
For investors with significant allocations to fixed income, now is a great time to ask your financial advisor whether your bond funds have the appropriate level of duration, given today’s rising interest-rate environment. Reducing duration may well entail increasing exposure to a different kind of fixed-income risk, but it may be a balance worth striking should rates continue to rise in the months ahead.