BONDS ARE OFTEN SEEN as the safe harbor in a retiree’s portfolio. But that sure hasn’t been the case this year.
As the long era of easy monetary policy—one that dates back to 2008—has come to an end, bond owners have been handed hefty losses. With interest rates rising and the Federal Reserve tightening, many investors have come to understand the risks they run with bonds.
Was there a way to know the risk beforehand? Yes, using a measure called duration. Most investors know that when interest rates rise, bond prices fall, and vice versa. Duration tells us how much a bond’s price might rise or fall in response to a specific change in interest rates. A bond fund with a duration of seven years would lose 7% if interest rates rose by one percentage point. What if rates fell one percentage point? The fund would gain 7%.
When interest rates climb, a bond fund with a shorter duration will lose less than a longer-duration fund. Here’s an example: The Bloomberg Barclays Aggregate Bond Index currently has a duration of 6.2 years. It’s lost 18.5% in 2022 through Oct. 31, as interest rates have risen. Its close cousin, Bloomberg Barclays Intermediate Aggregate Bond Index, has a shorter duration—4.5 years. It’s lost less, down 13.9% year-to-date.
Duration measures how long it will take investors to recover their purchase price through the cash flows from a bond. Longer maturity bonds have a higher duration because it can take years longer for an investor to be repaid.
Analysts calculate duration from five pieces of data: years to maturity, current yield, face value, coupon rate and frequency of payments. Often, a mix of these factors is used. Fear not: You don’t need to know all the details. You just need to know the number to better understand an investment’s risk.
Investors should check back because duration can change over time. A bond’s duration can drop as the years pass and the bond draws closer to maturity. Duration can also shift a bit within a bond fund. For instance, an intermediate-term bond fund’s duration might drift as hundreds of individual bonds move into and out of the portfolio as the fund pursues its mandate to hold only intermediate-term securities.
Canny investors employ duration to amplify returns, in a way similar to using leverage to goose results. Holding long-duration bonds was beneficial for investors who built bond portfolios between 2008 and 2021, a period marked by generally declining and ultra-low interest rates.
Now that rates are rising, however, the same aggressive portfolios are being whipsawed in ways investors might not have anticipated—unless they knew their duration. Unwary investors might be surprised to see their portfolio’s “safe” bonds down around 14%—in a year when the broad stock U.S. stock market is off 17%.
Duration isn’t limited to bonds. It can be calculated for stocks, though less precisely. Stocks don’t have the defined maturity or coupon rate of bonds, features that provide more certainty to bond returns.
Indeed, more assumptions drive stock durations. They’re often calculated using dividend rates and an assumed selling date. That last factor—the holding period assumption—is a critical bit of guesswork when calculating duration.
A simple measure of stock duration might calculate how many years it would take for the dividend payments to equal a stock’s current share price. From this, an investor could estimate how long it would take to be repaid for buying shares at today’s price.
Stock durations can vary hugely between growth and value stocks. Duration for value stocks is lower because mature, profitable value stocks often throw off strong dividend flows that would add up to the current share price relatively quickly.
When investors pay high prices for growth companies that may be unprofitable right now, they’re expecting those companies to earn enough later to support today’s higher valuations. Because those cash flows aren’t expected until well into the future, their duration is necessarily much higher. If those stocks also sell for high price-earnings (P/E) ratios, their durations may be extraordinarily high—a red flag for investors.
Sometimes, to support such nosebleed prices, the assumed holding period needs to be forever, or close to it. Think of pandemic-era favorites like electric truck maker Rivian, plant-based burger maker Beyond Meat and exercise equipment maker Peloton. Their incredibly high P/E ratios meant the stocks had extra-high durations. Sure enough, when interest rates began to rise, their share prices nosedived.
Every asset’s value is affected by interest rates. That’s why duration can be an investor’s ally—especially in an era where interest rates are no longer artificially suppressed by central banks worldwide.
Phil Kernen, CFA, is a portfolio manager and partner with Mitchell Capital, a financial planning and investment management firm in Leawood, Kansas. When he’s not working, Phil enjoys spending time with his family and friends, reading, hiking and riding his bike. You can connect with Phil via LinkedIn. Check out his earlier articles.