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Fixed-Income Insights

Focusing solely on a fixed-income security’s sensitivity to interest-rate changes can cause investors to overlook other important factors affecting performance.

 

In Brief

  • Duration, which is a measure of a bond’s price sensitivity to changes in interest rates, is an important metric in fixed-income analysis.
  • But it’s not necessarily a reliable indicator of performance. For example, a U.S. Treasury security and a high-yield corporate bond (see article text) with nearly the same duration experienced widely different total returns in 2013.
  • Other factors, including the security’s underlying income characteristics and prevailing economic conditions, can play an important part in total return.
  • Effective fixed-income analysis encompasses industry and company fundamentals, an understanding of macroeconomic conditions, and market- and security-specific factors.
  • The key takeaway—Investors would be wise to look beyond duration when deciding how to meet their investment goals and manage their expectations for different types of bonds.

 

If duration is a measure of volatility, “What’s my duration?” sounds like the right question. But relying on duration as a predictor of performance—or even volatility—can be misleading.

Duration does measure the price sensitivity of a bond (or a bond portfolio) by approximating a bond’s change in price for a 1% move in interest rates. (Generally, the larger the duration, the greater the interest-rate risk or potential reward for underlying bond prices.) For example, if the yield of a bond with a duration of 4.0 rose 100 basis points (bps), one would expect the price of that bond to fall by about 4%. But what causes the yield of one bond or group of bonds to move may have no influence, or even the opposite effect, on another bond’s yield.

Take, for example, two different bonds with similar durations and how their prices moved in 2013. Chart 1 shows the performance of a U.S. Treasury bond with a coupon of 1⅛% due May 2019, and a below investment-grade corporate issue, Viking Cruises Guaranteed Notes with a coupon of 8½% due October 2022. The durations used to measure price responsiveness in these two bonds are almost identical, yet the performance differences are dramatic.

Although past performance is not a reliable indicator of future results, despite both bonds having durations close to 6.25, the Treasury bond delivered a negative return of -3.58% for 2013, while the Viking Cruises notes provided a positive total return of 12.04%. In terms of price movement alone—that is, excluding the effect of the interest income provided by the bonds—the Treasury issue fell more than 4.6%, while the Viking Cruises security rose almost 4.8%.

Chart 1. Issues with Similar Duration Can Display Widely Divergent Total Return Performance
Total returns for the year ended December 31, 2013

Source: Bloomberg.
*U.S. Treasury bond with a coupon of 1⅛%, maturing May 31, 2019.
ƗViking Cruises Ltd. $250 million senior unsecured guaranteed notes with a coupon of 8½%, maturing October 15, 2022.
Past performance is no guarantee of future results.
The historical data shown in the chart above are for illustrative purposes only and do not represent any specific Lord Abbett mutual fund.
Effective duration takes into account the way in which changes in yield will affect the expected cash flows. It takes into account both the discounting that occurs at different interest rates as well as changes in cash flows.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. The Viking Cruises notes referenced in the chart above were guaranteed by certain existing subsidiaries of Viking Cruises Ltd. representing approximately all of the company's earnings before interest, taxes, depreciation and amortization (EBITDA) and about 97% of assets as of June 30, 2012, according to information from Moody’s.  An unsecured note is not backed by any collateral and therefore presents the most risk to lenders (investors in the notes). Due to the higher risk involved, the interest rates on these notes are higher than with secured notes. Senior notes take precedence over other unsecured notes and must be repaid in the event of bankruptcy. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal.
 

Why is there such a dramatic difference in total return?  Clearly, there are factors other than duration that influence such an outcome. The income effect mentioned earlier contributes significantly to the performance disparity. The more than 7% yield advantage of the Viking Cruises issue is a formidable head start over the Treasury issue.

While the income differential is obvious enough, the price movement of each bond is worth a closer look. For example, investors’ expectation of continued and possibly improving U.S. economic strength could influence both securities in different ways. A more robust economy could have had a negative influence on Treasury bonds if investors concluded that such strength could 1) spark inflation, thereby reducing bond prices, or 2) prompt the Federal Reserve to reduce further the purchase of Treasury bonds in its quantitative easing program, which could lift interest rates on government securities. At the same time, economic strength could 1) reduce the likelihood of defaults among lower-quality credits such as Viking Cruises (rated ‘B3’ by Moody’s) or 2) lead to increased revenues and profitability possibly leading to an upgrade in credit quality.

Supply and demand could also factor into price movement. The low current income and yield of Treasury securities could be unattractive to some investors, while others might be attracted to the current income and yield of lower-quality securities, despite the credit risk. There also might be issues specific to industries or individual credits that could influence demand and impact price.

A broader analysis reveals that performance differences extend beyond this example of two individual bonds. Comparing an index of U.S. Treasury bonds to a diversified index of high-yield bonds produces performance results similar to the individual bond comparison above. The BofA Merrill Lynch 3-7 Year U.S. Treasury Index, with an effective duration of 4.56 as of December 31, 2013, produced a negative return of -1.94% in 2013, according to Bloomberg, compared to a positive return of 7.41% for the BofA Merrill Lynch U.S. High Yield Constrained Index with an effective duration of 4.30 as of December 31, 2013.

Once again, performance and volatility are influenced by factors beyond duration. Instead of “What’s my duration?” investors may gain more insight by asking, “Which bonds do I own?”  In other words, how will the bonds in a portfolio react to changes in:

  • The economy
  • Market supply and demand
  • Inflation
  • Global uncertainty

To be sure, duration is a valuable metric for portfolio managers. It gives them a sense of how bonds will likely react to changes in interest rates. But good asset managers navigate portfolio risk beyond duration by gaining a thorough understanding of industries, by researching individual companies and their management, stress-testing portfolio holdings for different economic scenarios, and by anticipating other consequences, including those due to portfolio concentration, liquidity, and call risk. Investors would be equally wise to look beyond duration when deciding how to meet their investment goals and manage their expectations for different types of bonds.

 

 

ABOUT THE AUTHOR

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The Fund seeks to deliver current income and the opportunity for capital appreciation by investing primarily in high yield corporate bonds.

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