Primary risk factors that must be matched in constructing bond portfolios
Effective bond indexing—that is, constructing a bond portfolio that matches a benchmark index—need not fully replicate the bond index. Instead, you can achieve this balance by matching the primary risk factors of the managed index to the benchmark.
Primary portfolio risks that must be matched include interest rate risk (duration), yield curve twists (the present value distribution of cash flows and key rate duration), spread risk (spread duration), credit risk (duration contribution by credit rating), and optionality (exposure to a call or put). We’ll discuss each of these risks in this series.
What is duration?
Effective duration (also known as option-adjusted duration or adjusted duration) measures the portfolio’s exposure to a parallel shift in the yield curve. Due to the measure’s linearity, it doesn’t fully capture portfolio changes in response to non-parallel shifts in the yield curve. Generally, a higher bond duration implies the investor will have to wait longer for the payment of coupons and return of principal and the greater the price decrease in the bond as interest rates rise. The converse is also true. When interest rates decrease, the higher the duration, the greater the security’s price increase.
What are the primary factors that determine duration?
Duration is primarily affected by the coupon, yield, and time-to-maturity. Other things remaining constant:
So we can infer that interest rate risk is higher in low-coupon or zero-coupon (ZROZ), lower-yield, and longer-term bonds. ETFs investing in zero-coupon bonds include the PIMCO 25+ Year Zero Coupon U.S. Treasury Index Fund (ZROZ). ETFs investing in longer-term bonds include the iShares 20+ Year Treasury Bond ETF (TLT) and the iShares 10-20 Year Treasury Bond (TLH).
How can investors mitigate interest rate risk in bond investments?
Investors can get around interest rate risk by investing in floating-rate ETFs like the Market Vectors Investment Grade Floating Rate ETF (FLTR) and the iShares Floating Rate Bond (FLOT). The interest rates on floating rate bonds aren’t fixed but reset at periodic intervals, so investors can benefit from rising rates. This factor is especially important because, as economic growth in the U.S. gains traction, the Fed is expected to tighten the base rate. This is likely to result in rate increases across the credit and maturity spectrum, all else constant. FRNs can help investors benefit from increasing interest rates.
To learn more about floating rate notes, please read the Market Realist series Why investors should look at floating rate notes as an option.
Why is duration not totally adequate in measuring interest rate risk?
Duration overestimates price decreases and underestimates price increases in portfolio values in non-linear yield curve shifts. Also, as parallel shifts in the yield curve are extremely rare, additional measures are required to measure primary portfolio risks like convexity and key rate duration. To learn more about how these measures are used to measure changes in bond portfolio values, please move on to the next part of this series.