It’s Not How Much Duration You Hold, It’s Where You Hold Your Duration
Rising rates in the second half of the year have brought year-to-date returns for the US Aggregate (“Agg”) benchmark index negative. Anticipated rate cuts by the US Federal Reserve (“Fed”) late next year could support a more positive outcome for bond investors. But a “bull steepening” of what is now close to a historically inverted yield curve may leave risk-adjusted returns of longer maturity bonds lagging those of shorter maturities. And today, “flight-to-quality” means holding shorter rather than longer maturity bonds as post-COVID structural changes to the bond market likely persist. This makes where investors hold their duration even more important than how much duration they hold.
- Lessons from the taper tantrum: A decade ago, yields moved dramatically higher following indications of an early tapering of Quantitative Easing (“QE”) purchases from the Great Financial Crisis (“GFC”) era. The market feared the implications of this new element of Quantitative Tightening (“QT”), focusing its concerns on the longest maturity interest rates. Today, the combined effect of QT and increased Treasury supply may lead to a similar outcome of increased pressure on longer maturity bonds.
- The impact of a historically inverted yield curve: A decade later, yield increases have been led by the shortest maturities, resulting in a historically inverted yield curve. Next year, the Fed is expected to cut rates to keep pace with falling inflation. This means that rate declines would be concentrated in the front end rather than the back end of the curve, making shorter maturities the best performing areas of the bond market. Investors with exposure to the Agg benchmark index may be left behind as roughly 94% of the benchmark’s duration lies in maturities greater than 2 years.
- Short maturities may outperform during “flight-to-quality”: Stock-bond correlation moved significantly more positive during the post-COVID inflation, undermining the role of bonds as a diversifier in portfolios. More recently, the diversifying properties of bonds were somewhat restored during banking crisis concerns in March. But a closer look reveals an important implication of the historically inverted yield curve: bonds are not rallying nearly as much when stocks sell off. Rather, shorter dated maturity notes have exhibited the most hedging efficacy versus stocks.
It’s not how much, but rather where you hold your duration
Rising rates in the second half of the year have brought year-to-date returns for the US Aggregate (“Agg”) benchmark index negative—a disappointing turn to the “bonds are back” narrative. Looking ahead to 2024, the market anticipates that the Fed will cut interest rates. But rate declines may be led by the short end of the curve, and this “bull steepening” would leave the risk-adjusted returns of the Agg lagging those of shorter duration bonds.1
More broadly, this scenario highlights a shift away from the long-standing outperformance of the long end for portfolio hedging. The factors that were underpinning that performance: (i) hedging efficacy led to levered long end positions from risk parity strategies, (ii) a historic drop in both the level and variability of interest rate volatility suppressed term premium, and (iii) the Fed put, unbridled by inflation concerns, led to interest rate suppression as a tool for policy accommodation. Each of these dynamics are unlikely to return in a post-COVID investment environment, returning bond market “flight-to-quality” insurance to its traditional role in the front end of the yield curve.
Traditional “core” fixed income tracking the Agg mostly provides exposure to the long end, as shown by the distribution of Key Rate Duration (“KRD”) in Figure 1. KRD measures interest rate sensitivity by maturity. Not only does the Agg have a high level of duration (6.25 years), but the majority of that duration (93.5%) comes from maturity points greater than 2 years.