Fixed-income investing doesn’t have the same glamour and round-the-clock news coverage as stock investing. There’s no such thing as a “meme bond.”
Regardless, bonds are a crucial component of a properly allocated portfolio, and investors would be well served by having at least a passing familiarity with concepts like bond duration, which can affect their returns.
Still, more than once I’ve had clients balk at the idea of investing in bonds, offering the explanation, “They don’t return as much as stocks.” That’s where it becomes the financial advisor’s job to help clients understand the value of bonds in a portfolio and factors such as bond duration.
In a March 10 blog post, Vanguard’s John Croke and Samuel Martinez wrote, “Because yields are higher today than at any time since the 2008 global financial crisis, bonds now have better expected returns and can cushion against further price declines. An overweight to cash or very short-term securities worked well in 2022, but adding more duration exposure could prove valuable going forward.”
So what exactly is bond duration, and why does it matter for investors? Here are some key things for investors to be aware of:
— What is bond duration?
— Duration, interest rates and bond prices.
— Balancing bond term and credit quality.
— Bond duration and portfolio construction.
— Stay calm, carry on and adapt to bond markets.
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What Is Bond Duration?
“Duration is the measure of a bond’s sensitivity to changes in interest rates,” says Andrew Latham, a certified financial planner and director of content at SuperMoney.com. “Think of it as the bond’s time to maturity on steroids. It takes into account not only the time until the bond’s principal is paid, but also the size and timing of its coupon payments. It’s like the bond’s internal clock that ticks faster or slower, depending on the level of interest rates,” Latham adds.
He offers a parallel to preparing a meal: The time to cook a dish in the oven depends on both the temperature and the size of the dish. Similarly, Latham says, a bond’s duration depends on both its interest rate and its cash flow.
“A bond with a longer duration will be more sensitive to interest rate changes, while a bond with a shorter duration will be less sensitive,” he says.
Duration, Interest Rates and Bond Prices
Devin Carroll, owner and lead advisor at Carroll Advisory Group in Texarkana, Texas, says he likes to keep the explanation simple when discussing duration with clients.
“Duration is complex, but you can think of it as a weighted average of the time it takes for you to receive the cash flows from your bonds,” he says. “What it really helps us understand is how much the value of your bonds will fluctuate with changing interest rates.”
Eric Presogna, founder and CEO of One-Up Financial in Erie, Pennsylvania, says, “I tend to explain it like I would to my 11-year-old son using simple math. For every 1% move in interest rates, bond prices will change approximately 1% in the opposite direction for every year of duration.”
Balancing Bond Term and Credit Quality
The two main factors behind returns are bond term and credit quality. The latter refers to a bond’s rating. In other words, how likely is it that the issuer will be able to service its debt and repay bondholders?
I’ve often turned to research from Dimensional Fund Advisors to help clients understand the role of bonds in their portfolios. In a Feb. 23 research paper aimed at financial advisors, Dimensional’s Matthew Wicker and Kaitlin Simpson Hendrix wrote, “On average, bonds with a longer duration provide greater exposure to the term premium, and those with lower credit quality provide more exposure to the credit premium. Thus, allocations to such bonds may be appropriate for investors seeking capital appreciation.”
Over the past three decades, they added, annualized returns have been higher for intermediate government and credit bonds, which have a longer duration and lower credit quality, than for short-term government bonds, which have a shorter duration and higher credit quality.
But they also point out that an allocation to short-duration, high-credit-quality bonds can mitigate overall volatility in an equity-heavy portfolio, “while maintaining the ability to pursue higher expected returns.”
[ READ: 6 Steps to Get Started With ESG Investing ]
Bond Duration and Portfolio Construction
You might do your own research on duration but still require an advisor’s expertise to construct a portfolio that meets your unique needs. When constructing portfolios, advisors take bond duration and the current investing climate into account, along with each client’s unique situation.
“Each investor has their own risk tolerance and target returns, so this really depends on each investor’s own circumstances,” says Serge Berger, principal and co-founder of Blue Marlin Advisors in Winter Park, Florida.
“However, bond durations traditionally are adjusted throughout the business/market cycle,” he adds. “In rising-rate environments investors tend to stick to shorter duration, whereas when rates begin to fall, longer duration assets and bonds tend to be allocated.”
While not being reactive in the moment, seek your advisor’s help to anticipate what may be around the corner and be prepared to reallocate or rebalance, or simply to have discussions about conditions that may affect returns.
Stay Calm, Carry On and Adapt to Bond Markets
If you have fewer assets to tide you over in retirement, you might understandably become nervous when news events send your investments lower. An event like the Silicon Valley Bank failure, coupled with the bailout of banking giant Credit Suisse, can cause you to worry about the value of your portfolio. If you’re close to retirement without much opportunity to earn more income, those fears are very real and justified.
“My base case, for now, is that the economy is slowing at a faster pace each month and credit problems will ultimately force the Federal Reserve to cut rates. This should shift the entire curve lower,” Berger says. “The closer we get to the point where the Fed will be forced to cut interest rates somewhat, short-term interest rates will adjust lower more sharply.”
Robert Reilly is on the finance faculty at Providence College and serves as an investment consultant at North Atlantic Investment Partners. He says an investor’s approach to bonds should be adjusted to current market conditions.
“Bonds were in a long, 40-year bull market from 1981 to 2021, where interest rates declined steadily from levels in the mid-to-high teens to 1% to 2%,” he says. “In the long bull market, long durations served investors well. The long-term downtrend in rates looks to be history. We have shifted to a new era, which has been marked by higher inflation levels. To protect capital, in rising-interest-rate environments, shorter durations are advised.”
He says bonds with longer durations will carry more risk and their prices will be more volatile, compared with lower-duration bonds as well as bond funds. He refers to a condition called modified duration, which is the measurable change in a security’s value relative to a change in interest rates.
“Technically speaking, a bond’s modified duration is an estimate of how much a bond’s price will rise or fall with a 1% change in the yield to maturity,” Reilly says.
If the Fed does indeed keep rates higher for longer, as it indicated it would do before the Silicon Valley Bank collapse, a bond with a 10-year duration can lose 10% of its value with an additional 1% rise in rates.
Presogna says he expects short-duration bonds to outperform longer-duration securities in the near term, with a caveat: “At some point, however, the Fed may force the U.S. economy into a recession, which could lead to rate cuts that are more favorable to longer-duration bonds.”
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Why Bond Duration Matters for Investors originally appeared on usnews.com
