How to think about duration

21 November 2018 | Portfolio construction


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Leo Schulz: In an environment of rising interest rates, how should investors think about duration? My name is Leo Schulz, and I have with me Ankul Daga a Senior Investment Strategist at Vanguard Europe.  Ankul, interest rates are rising and that will have an impact on a fixed income allocation in a portfolio.  How should investors respond to that?

Ankul Daga: As interest rates rise, it is not necessary that the fixed income portion of the portfolio would lose its value.  What really matters is the yield of the portfolio. 

Leo Schulz: Now, that is a somewhat unusual statement, Ankul.  I think most people would expect that as interest rates change, yields will change in accordance, so what is determining the yield other than interest rates?

Ankul Daga: So besides interest rates, yields are driven by the demand and supply in the market and the term premium, so term premium is the premium investors demand for holding longer duration bonds as compared to shorter duration bonds, so those three factors determine the yield of a bond.  And what is really important to keep in mind is that the market tries to forecast that yield, so the market tries to price in that yield much before the interest rate increase happens. 

Leo Schulz: So as long, as an example, the Bank of England is announcing, explaining, predicting what it is going to be doing, then there won’t be surprises in the market and yields will be relatively stable. 

Ankul Daga: That is absolutely correct. 

Leo Schulz: But interest rates are going up, Ankul, and as they go up, however slowly, yields are likely to rise, even if it is not a direct correlation.  Surely, in that situation, the best place to be is in the hands of an active manager who can response to changing conditions. 

Ankul Daga: I think it is difficult being active.  I will say that with two kind of reasons.  One, because forecasting itself is a very difficult task.  If you look at the track record of professional forecasters who have been forecasting yields for the last five years, for every single year, a lot of forecasters have gotten the yields entirely wrong.  So, first, it is really difficult, really tricky.  And then the second part is that when you look at a portfolio, you have got to think about what is the fundamental role of bonds in a portfolio. 

Typically, bonds serve dual objectives, one is risk reduction against equities in the portfolio, and second is providing stable income.  When you hold a short duration bond, you reduce the risk reduction capability or the shock absorber that you have against equities in a portfolio.  What you also do is with a short duration bond, you reduce the income that you're going to get in that portfolio.  Essentially, what you're doing is you're reducing the income of the portfolio and significantly compromising the shock-absorbing capabilities of the bond allocation in the presence of uncertain outcomes. 

Leo Schulz: Yields do not move in direct correlation to interest rates.  Predicting the course of yields is very difficult and there is a very poor track record.  By bringing a portfolio into shorter duration, you reduce income, you reduce the value of your bond component in terms of a buffer or a shock absorber against volatility, and you're doing this for an outcome that is uncertain. 

Ankul, thank you very much. 

Ankul Daga: Thank you. 

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