While recent market volatility is leading many investors to look for the nearest exit, my colleague Russ Koesterich insists it’s time to stay the course while acknowledging that we may encounter some more bumps down the road. He has some suggestions for bond exposure, specifically sectors that look more attractive right now.
Duration is a term we use in the bond world that can help us determine an investment’s interest rate risk. Today, I’ll explore the basics: What duration means and how to apply it to your bond strategy.
When interest rates fluctuate, bond prices also shift. Rising rates push bond prices lower, while falling rates push bond prices higher. Duration, expressed as a number of years, measures a bond’s interest rate sensitivity: The higher the duration, the higher the interest rate risk. This means that if interest rates rise the price of a high duration bond will fall more than the price of a low duration bond.
Short, Medium and Long Duration
In fixed income, investors use the term “short” to denote a low duration, and “long” to denote a high duration. The duration of a bond is related to its maturity, with longer maturity bonds generally having higher durations. To be fair, longer maturity bonds don’t always have longer durations, but this is the case more often than not. Let’s take a look at some definitions for different duration ranges.
1. SHORT DURATION
When we say “short duration”, we are generally referring to bonds that mature within three years. Short duration bond strategies tend to have lower yields than long duration bond strategies, but when interest rates rise, short duration strategies will experience a smaller price drop.
2. MEDIUM DURATION
This refers to bond funds with average maturities of 3 to 10 years. Usually, yield is higher with these types of bond strategies than with short duration, while interest rate risk is lower than long duration.
3. LONG DURATION
This generally encompasses bond strategies with an average maturity of more than 10 years. This strategy usually offers the highest interest rates, which can be optimal in a falling rate environment. But when rates rise, long duration bond strategies can experience sharp price declines.
What to Do Now
My colleagues and I believe that U.S. economic data, including the recent jobs report, reinforce that a Fed rate hike is on the horizon, likely later this year. It is unclear if the Fed’s move will cause interest rates to rise in the near term, but we do expect that we will at least see more interest rate volatility. Investors should take care to reevaluate their duration exposure accordingly.