Duration: Not Debunked, Just Practically Applied

by:
MainStay Investments

When will interest rates rise and by how much? This question has been analyzed and debated continuously over the years, as the low interest-rate environment persisted.

When we talk about rates, we are generally referring to the target Federal Funds Rate or the yield on risk-free U.S. Treasurys, as these have a significant impact on borrowing costs and investment returns for individuals and businesses alike. For fixed-income investors, the expected rate levels and speed at which they change are factors that help determine which portion of the market they will focus on, and where on the yield curve they will position their portfolios. Therefore, investors need to know a bond’s sensitivity to interest-rate fluctuations, which is where we turn to duration.

Duration is defined as a measure of the approximate sensitivity of a security to a change in interest rates, providing, in other words, a measure of interest-rate risk. The concept has been studied by students of the market, both formally and informally, for many years and it has special significance for fixed-income investors navigating today’s rising interest-rate environment.

Yet, the perception that duration is the sole driver of interest-rate sensitivity, and that a bond or portfolio with less duration will always be more insulated from the effects of a rate increase vs. portfolios with higher average duration, is flawed. As this article seeks to explain, there are important nuances to consider, as it relates to interest-rate sensitivity in the high-yield and high-yield municipal bond markets, and they hold meaningful implications for investors in today’s environment.

When Duration Works

Duration is a mathematical calculation that works almost perfectly for risk-free bonds, where interest-rate risk is the key point to consider. That’s what duration is – a bond price’s sensitivity to changes in interest rates. Note, that there are different types of duration, and those types have differing calculations, but ultimately, they all represent interest-rate sensitivity.

For our argument, let’s ignore convexity and the fact that duration assumes an instantaneous parallel shift in the yield curve. Keeping that caveat in mind, Figure 1 represents a plot of monthly changes in five-year Treasury yields, alongside average price changes of the Bloomberg Barclays U.S. Treasury 3-7 Year Index, dating back 20 years. The dashed orange line represents the expected plots, given the average duration over the 20-year periods, and the solid blue line is the linear trend line, given observed results. In simple terms, the two lines obviously track each other quite closely, and outliers are also limited. In technical terms, the R-squared (R2) of the regression comes in at 0.90, meaning that 90% of the changes in bond price are explained, or in other words, driven by the changes in the interest rate.

Figure 1: Duration as an Effective Measure of Interest-Rate Sensitivity

Sources: Treasury.gov and Bloomberg Barclays, as of 3/31/17.

Duration’s (Limited) Applicability to High-Yield Bonds

While duration typically proves to be a strong and accurate measure of interest-rate sensitivity for risk-free bonds, we believe it is a less important factor for high-yield bond portfolios, which warrant additional consideration.

To illustrate this point, we replicated our regression analysis using asset classes from the other end of the credit spectrum, assessing duration’s ability to describe price movements, given interest-rate changes for high-yield corporate bonds (Figure 2) and high-yield municipal bonds (Figure 3).

Figure 2: Duration Applied to High-Yield Corporate Bonds

Sources: U.S. Department of Treasury and Bloomberg Barclays, as of 3/31/17.

Figure 3: Duration Applied to High-Yield Municipal Bonds

 

Sources: U.S. Department of Treasury and Bloomberg Barclays, as of 3/31/17.

In Figure 2, the dashed orange line represents the expected plot of price changes for the Bloomberg Barclays U.S. High-Yield Index, given changes in five-year U.S. Treasury yields. The solid blue line shows the trend line based on observed results. Unlike the scenario represented by Figure 1, Figure 2 indicates that there is little to no relationship between changes in Treasury yields and changes in high-yield bond prices. This point is made with the R2, which indicates that just 2.6% of the changes in the high-yield price can be attributed to changes in yield. Furthermore, in the case of high-yield corporate bonds, it’s interesting to note that the trend line actually has a positive slope, which would imply that empirically, the average price of the high-yield index actually increased when the five-year Treasury yield rose. This is to be expected, given the negative correlation between Treasury bonds and high-yield bonds over the 20-year time period.

Figure 3 features the same regression analysis once again, plotting monthly price changes of the Bloomberg Barclays High-Yield Municipal Bond Index alongside changes in the 10-year Treasury rate (due to a longer average maturity for this index, compared to its corporate counterpart). The results gleaned from the 20-year time period are striking, with the key point being that high-yield municipal bond prices have virtually no relationship with changes in the 10-year interest rate. Once again, this can be illustrated technically by the R2, which indicates that just 0.40% of the price changes for the high-yield municipal bond index can be attributed to interest-rate fluctuations.

Does This Mean Duration Is Wrong?

Not exactly. Duration is the measure of a bond’s price sensitivity to its own change in yield. In order for duration to accurately measure a high-yield bond’s price sensitivity to Treasury yields, the yield of non-investment-grade credits would have to move in lockstep with that of Treasurys, and that simply isn’t the case. The reason is due primarily to the fact that high yield, as an asset class, is much more credit-sensitive than interest-rate sensitive, a theme that can be applied in both taxable and tax-exempt markets.

First, keep in mind that interest rates tend to rise when the economy is expanding. For corporates, a more important driver of high-yield prices is the financial health and credit risk of the companies issuing those bonds. In a growing economy, many companies will generate profit increases, improving their ability to service existing debt, therefore making their bonds less risky investment propositions. Similarly, many high-yield municipal bonds are backed by economically-sensitive project revenues, which can strengthen amid improving economic environments, providing a growing revenue stream from which debt is serviced.

Second, since spreads are the market’s way of pricing credit risk and the probability of default, they tighten and widen, based on investor risk appetite and the perceived creditworthiness of the issuer. Therefore, it is entirely plausible for the spread – the difference in yield between the high-yield bond and a risk-free bond with the same maturity – to tighten and fully absorb an increase in Treasury yields. For example, if five-year Treasurys yield 2% and high-yield bonds yield 6.5%, the spread is a much larger component of the overall yield of the bond than the risk-free rate. The same can be said of high-yield municipal bonds, especially when one considers the tax-adjusted spread. By this rationale, it makes sense that rising rates coincide with an improving economic environment, which facilitates stronger issuers and lower default risks, leading to tighter spreads and bond prices that are more insulated from the effects of rising interest rates. The counter move of credit spreads typically offsets some of the impact of rising Treasury yields.

However, it is worth noting that when credit spreads are tighter, there is less of a cushion, and therefore, high-yield bonds may not be completely insulated from wider bond market volatility.

In summary, if interest rates move higher, high-yield bonds may perform well, as the rebounding fundamentals of lower-rated paper may absorb, and potentially outpace, the negative impact of higher rates.

A Practical Perspective

To put all of this into context, we looked at four periods of rising interest rates in order to compare expected results based on duration with the actual results of the respective periods. The two charts below, Figure 4 for high-yield corporate bonds and Figure 5 for high-yield municipal bonds, produce two important points: 1) that the price return of the bonds did not behave in the way duration suggests, and 2) that the larger coupons from high-yield bonds have significant impacts in a total return context.

Figure 4: Cumulative Performance during Previous Rising Rate Periods: High-Yield Corporate Bonds

Sources: Morningstar Direct and Bloomberg Barclays, 3/31/17. Note: Expected price returns based on interest rate change and duration.

Figure 5: Cumulative Performance during Previous Rising Rate Periods: High-Yield Municipal Bonds

Sources: Morningstar Direct and Bloomberg Barclays, 3/31/17. Note: Expected price returns based on interest rate change and duration.

Conclusion

The duration of a bond or fixed-income investment portfolio is a frequently referenced risk measure that is made all the more relevant in today’s interest-rate environment. However, there are important details to keep in mind as one applies the measure to the different segments of the fixed-income market, particularly in high yield. High-yield bonds, both corporate and municipal, represent more esoteric segments of the bond market that incorporate the idiosyncrasies of lower-rated bonds, making them more credit-sensitive than interest-rate sensitive. This has important implications for fixed-income portfolios, namely that these segments are driven more so by unique factors that make underlying credit research increasingly important.

 

Definitions:

3-7 year bonds are public obligations of the U.S. Treasury with a remaining maturity from 3 up to (but not including) 7 years.

Exclusions:

  • Treasury bills are excluded (because of the maturity constraint).
  • Certain special issues, such as flower bonds, targeted investor notes (TINs), and state and local government series (SLGs) bonds are excluded.
  • Coupon issues that have been stripped are reflected in the index based on the underlying coupon issue rather than in stripped form. Thus STRIPS are excluded from the index because their inclusion would result in double counting. However, for investors with significant holdings of STRIPS, customized benchmarks are available that include STRIPS and a corresponding decreased weighting of coupon issues.
  • Bills, coupons, and bellwethers
  • As of December 31, 1997, Treasury Inflation-Protection Securities (Tips) have been removed from the Aggregate Index. The Tips index is now a component of the Global Real index group.

High-yield bonds are represented by the Bloomberg Barclays U.S. High Yield Index, which covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moody’s, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included.

High yield municipal bonds are represented by the Bloomberg Barclays High Yield Municipal Bond Index, an unmanaged index that includes municipal bonds that are non-rated or rated Ba1 or below. They must have an outstanding par value of at least $3 million and be issued as part of a transaction of at least $20 million. The bonds must have a dated-date after December 31, 1990 and must be at least one year from their maturity date.

R-squared is a statistical measure of much of a variation can be explained by given model. In this discussion, we’re looking at what percentage of bond price changes (variation) can be attributed to changes in the interest rate (model).

  • R-squared = Explained variation / Total variation
  • R-squared is always between 0 and 100%:
    0% indicates that the model explains none of the variability of the response data around its mean.
    100% indicates that the model explains all the variability of the response data around its mean. ***

By reading this blog, you accept the Terms of Use.

Index performance is shown for illustrative purposes only and does not predict or depict the performance any specific investment. Indices are unmanaged, include the reinvestment of dividends and cannot be purchased directly by investors. Past performance does not guarantee future results.

About Risk:

Bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner.

High yield securities (junk bonds) have speculative characteristics and present a greater risk of loss than higher quality debt securities. These securities can also be subject to greater price volatility. Diversification does not guarantee profit or protect against loss.

Duration measures interest-rate sensitivity. The longer the duration, the greater the expected volatility as rates change. Fixed Income investing entails credit and interest-rate risks. When interest rates rise, bond prices generally fall, and a fund’s share prices can fall.

MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services.

NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Adam Schrier, Josh Monroe

MainStay Investments

Joshua Monroe is a Director of Product Management at MainStay Investments covering the firm’s municipal bond and asset allocation investment strategies. Adam Schrier is a Director of Product Management at MainStay Investments covering taxable fixed income and energy equity strategies.

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