The importance of duration in fixed interest

Summary: Bond returns represent a cost of borrowing for companies and governments.

Key take-out: A higher bond duration means the bond’s value is more sensitive to changes in interest rates.

Choosing fixed interest investments in a low interest rate environment is challenging, due to the ‘risk’ of rising interest rates having a direct negative return on this part of your portfolio.

As interest rates rise, the value of bonds falls. This is described as the inverse relationship between bond prices and interest rate movements. However, as we think about interest rate movements, the ‘duration’ of a bond portfolio becomes important, as do the fees that are paid from the portfolio.

While investors are able to access fixed interest exposure directly – via term deposits and ASX-listed fixed interest investments – the reality is that if an investor wants exposure to a diversified portfolio of corporate and government bonds, the high price of individual bonds means they will likely have to do this through a fund manager.

One of the key elements of this relationship that needs to be considered is fees. In the part of a portfolio in which you might be hoping for a modest return premium over the cash rate – perhaps an extra 1 per cent of returns (the five-year return for the Vanguard index-based diversified bond return is 3.63 per cent per annum to the end of October, 2018) – fees become extraordinarily important. This is not only because of the impact that they have on return, but because of the way that they impact the risk and return relationship.

A new way of thinking about bonds

We tend to think about a fixed interest investment from the point of view of cash flows to us as investors – our potential returns. I think it is instructive to think of our interest returns from the perspective of the company or government – that it is the cost of their borrowing.

Clearly, they want to borrow for as little as possible. If they are paying 4 per cent interest on a bond, it is only because they could not find an investor willing to lend them the money at 3 per cent, or 3.5 per cent. If you are paying too much in fees, you will either have to have a portfolio which takes on more risk (i.e. higher yielding bonds), or accept a lower return.

At a more extreme level, the discussion about your investment returns being the cost of borrowing for a company/government is the reason why risk and return are profoundly related.

No company is going to borrow money at 14 per cent (i.e. offer you a return of 14 per cent) unless they have been knocked back when they asked for a 4 per cent return, then a 6 per cent return, then an 8 per cent return, and so on. This is worth keeping in mind the next time a 14 per cent mezzanine finance scheme is touted to you.

Duration

In the current investment landscape in Australia, much of our thinking centres around when the next interest rate rise might occur. We have now had more than two years with no cash rate movements, with the last movement in the cash rate being a fall of 25 basis points to 1.5 per cent, where it currently sits.

The last time the cash rate increased was all the way back in November 2010, when Ricky Ponting was still captaining the Australian cricket team. On this occasion, the cash rate was increased to 4.75 per cent, before the series of cuts which led us to our current position.

Given the current low level of interest rates, it seems likely that the next movement in interest rates will be up, meaning it is worth taking some time to understand the concept of ‘duration’ and interest rate sensitivity when talking about a bond portfolio.

In general terms, duration refers to the interest rate risk of a bond portfolio – the longer the duration, the more sensitive the portfolio will be to interest rate movements. Duration is a measure of the weighted average of the time to receive the cash flows from a bond.

The following represents a practical example of duration in bond portfolios. The SPDR S&P/ASX Australian Bond Fund (as at November 23, 2018) reports a modified adjusted duration of 5.63 years, and the Vanguard Index Diversified Bond Fund has an effective duration of 6.2 years. Both SPDR and Vanguard define their measure of duration as the sensitivity of the portfolio to a 100-basis point change in interest rates. If interest rates were to rise by 100 basis points, the value of the bond funds would be expected to fall by 5.62 per cent and 6.2 per cent, respectively. If interest rates were to fall by 100 basis points, the opposite would happen.

This nicely demonstrates the importance of understanding the relationship between interest rates and the duration of a bond portfolio. For those investors who look at their fixed interest investments and think that perhaps a shorter duration portfolio might help them feel more comfortable with interest rates toward historical lows, then moving some of their fixed interest assets to short-dated term deposits, adding bond funds targeting short-term bonds or taking some money from bonds and moving it to cash are strategies to consider.

Conclusion

Fixed interest investments have a crucial place in portfolios: they dampen volatility, provide some level of liquidity and provide a diversification effect.

We often talk about the technical analysis of share investments – price-to-earnings (PE) ratios, dividend yields and historical growth rates – but it would help investors to also engage with the way in which bonds work.

Given the likelihood that most investors in Australia will use a bond manager because of the high price of individual bonds, it is important to think about the impact that fees have on a bond portfolio.

In a time of historically low interest rates, the role of ‘duration’ in understanding the interest rate impact on a portfolio is important. If you are concerned about a duration that leaves you more exposed to interest rate movements than you would like, then increasing your cash exposure or looking to move some fixed interest investments into a bond fund targeting short-term investors may make sense.

Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.