Duration Is Not Defensive

Again, we are not calling for a systemic meltdown like the 2008 analog. However, in a late-cycle environment where a growth slowdown is plausible, maybe even likely, we think it is prudent to be positioned defensively. High yield and preferred securities have been pared back substantially. Credit quality has been increased. And our weighted average maturity profile has gone from over six years to four years. 


The playbook for asset allocators and risk parity funds for a growth slowdown is to have exposure to longer-dated treasuries which, in theory, should perform well in a risk-off environment. Indeed, in 2008, the playbook performed admirably, and correlations between longer-dated Treasuries and risk assets were negative. We expect that there will be times during the next slowdown that a similar inter-asset relationship exists. However, we do not think that extending duration in treasury securities offers a good risk-reward proposition. First, we could always be wrong. We think we are late in the cycle, but nobody really knows for sure. In an environment where wage growth continues to accelerate and inflation increases to over the Fed’s 2% target, thirty-year treasuries could be the worst place to be. And second, even if there is a growth slowdown, that does not preclude inflation from being stubbornly resilient. Going into the last recession, the thirty-year bond was yielding 5.5%. Today, it yields less than 3%. As such, we believe there is considerably less upside in a risk-off scenario. And finally, there are a number of trends we believe pose a risk to the long-end of the curve. Term premiums are negative. Fiscal deficits are likely to remain above $1 Trillion per year – potentially inundating the market with supply. We believe increased global issuance from Japan, Eurozone, and China will also provide investor alternatives, further crimping demand for U.S. Treasuries. The Federal Reserve, we believe, will be faced with the “Sophie’s Choice” of Central Banks. They will have to choose between fighting inflation and promoting growth. We believe they have tipped their hand and will choose growth over inflation in an environment where the two are not moving together. Since the Federal Reserve has much more control over the short-end of the yield curve, we believe the better risk-reward proposition is to shorten duration and increase credit quality. 

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Disclosure: This article is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. ...

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