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Financial Industry Insights from Advisors Asset Management
On November 23, 2015
AAM Viewpoints - Ignoring Duration is Not an Option
In September 2013, I was asked to review a portfolio for an advisor who was concerned about the interest rate risk in a client’s corporate bond portfolio. The portfolio was a well-diversified corporate bond ladder with a split-rated average credit quality and duration somewhat shorter than the Barclays Aggregate Bond Index. However, the advisor was concerned about rising rates and was adamant the portfolio should be reallocated to maturities no longer than two years. The advisor felt the interest rate risk in the portfolio was “too high because of the longer maturities.”
As a result of confusing duration and maturity, the client finds themselves reinvesting in a low rate environment. While focusing on maturity is one way to address interest rate risk, we feel the opportunity costs associated with this tactic can be too high. In many cases, income and yield are sacrificed unnecessarily in this blind focus on purging long maturities from a portfolio.
On the cusp of what may be the first Fed Funds Target Rate increase since June 2006, investors are bombarded by the rising din of the danger interest rate increases may pose. Our philosophy has always been to position assets where we believe we are going, not where we have been. For the average investor, we see little benefit in attempting to time changes in interest rates, and yet confusing maturity with duration does exactly that.
The importance and timeliness of understanding duration can be no clearer than the FINRA Investor Alert published 2013: “Duration – What an Interest Rate Hike Could Do to Your Bond Portfolio.” There is certainly a broad media focus on the risks which rising rates pose, but many investors and financial professionals remain confused as to how to best address it.
We’re obviously going to avoid the esoteric discussion of the various measures of duration in this commentary. Our focus here is to clarify that duration as a measure of interest rate risk is not the same as maturity. This is to say that how much would we expect a bond, bond fund or bond portfolio to move in price with a 100 basis point (1.00%) move in interest rates. In particular, and as the FINRA Investor Alert states, duration is a risk that is present in bonds, bond portfolios and bond funds.
Consider the two identically-rated issues in the example below. While each of the bonds has a similar maturity date, their durations are dramatically different. This difference in duration between these two bonds has little to do with their different maturities and more to do with their coupon and call structures.
Company A
Company B
Maturity
6/1/2025
7/1/2025
Call Date
6/1/2020
N/A
Coupon
5.00%
3.00%
Duration
4.53
8.87
Yield to Maturity
3.30%
2.11%
Yield to Call
2.01%
n/a
Maturity Value
$100.00
For illustrative purposes only.
A 1% increase in interest rates results in an estimated 4.53% decrease in the bond price for Company A. Whereas, the holder of Company B debt can expect an approximately 8.87% decline in price for the same movement in rates.
It should be clear that duration and maturity are fundamentally different metrics. Focusing only on maturity to address interest rate risk indicates a fundamental misunderstanding of the importance of duration. AAM believes managing interest rate risk is more tactical and incremental in nature. Understanding the difference between duration and maturity can help investors deploy tactics which balance where they feel rates are going with the need to meet their income objectives.
CRN: 2015-1102-5021R
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at https://www.aamlive.com/legal/commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.
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