Do Bond Investors Have To Take Duration Risk?

Duration giveth, and duration taketh away.

For much of the past 35 years, while interest rates were in a secular decline, duration (a measure of a bond’s sensitivity to changes in interest rates) was the best friend of bond investors. In 2018, it has become their worst enemy.

At one end of the spectrum, you have short-term Treasury bills (BIL) with a duration of 0.1 and a total return of 0.6% year-to-date. At the other end of the spectrum, you have long-term zero-coupon bonds (ZROZ) with a duration of 27.3 and a total return of -10.0%.

The correlation between duration and year-to-date returns in the table of popular bond ETFs below? -0.86.

Data Source: YCharts

While 10-Year Treasury yields have risen from 2.4% to 3.06% in 2018, the largest bond ETF (AGG) is down 2.81% and the largest bond mutual fund (VBTLX) is down 2.84%. The duration on both instruments is roughly 6 years.

If this trend continues through the end of 2018, it would be the worst year ever for U.S. bonds.

Needless to say, bond investors aren’t accustomed to such declines – bonds tend to be synonymous with safety. This mismatch between expectations and outcomes can lead to adverse behavioral responses (aka selling at the wrong time).

Which brings me to the title of this post: do bond investors have to take duration risk? Said another way: do bond investors have to be willing to accept short-term principal losses when interest rates rise?

In an aggregate bond fund like AGG, the answer is clearly yes, but what if we look outside the bond market to the sleepy world of certificates of deposit (CDs). Here we find something quite interesting, particularly for longer-term bond investors who do not need daily liquidity.

The highest yields on various CDs (from 1 year to 7 years) today are comparable (and oftentimes higher) to U.S. Treasuries with similar maturities.

Data Source: Bankrate.com and Stockcharts.com

And a 5-year CD (3.06%) has a higher yield than the AGG ETF (3.03%).

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Disclaimer: At Pension Partners, we use Bonds as our defensive position in our absolute return strategies for all of the above reasons. Bonds have provided a more consistent ...

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