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Balancing Income Portfolios: Taking Control of Bond Market Risk

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Part 2
Balancing Income Portfolios: Taking Control of Bond Market Risk PART 2 OF 4

The Sweet Spot on the Seesaw

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Moving away from cash in either direction on the seesaw increases return. On the rate-sensitive side, moving away from the center increases duration—a measure of interest-rate risk—but investors are compensated with higher yields. On the return-seeking side, higher yields compensate investors for rising credit risk.

There’s a catch, though: yields on bonds with different maturities don’t move in lockstep. When they rise, they rise on a curve, not a straight line. The further out one moves, the smaller the yield increase. Moving from cash to three-year government bonds can provide a hefty bump in yield. But the pickup available when moving from 10-year to 30-year bonds can be tiny. It’s a similar story on the return-seeking side: return expectations increase as one moves away from cash, but by ever-diminishing amounts. Moving from high-yield bonds to equity, for instance, increases returns only slightly, but doubles drawdown risk.

That means it’s almost never efficient to tilt all the way left or all the way right. In a rising-interest-rate environment, investors might be tempted to reduce all their interest-rate risk and load up on credit. But leaning that far in one direction would probably overexpose them to a single risk and leave them vulnerable to large drawdowns.

It would also overlook the critical contributions that duration makes to a fixed-income portfolio, namely stability, diversification and income. Sure, government bonds, mortgage-backed securities and even many investment-grade corporate bonds are highly sensitive to rate movements. But as these bonds mature, their prices drift back toward par. That means investors can reinvest the coupon income in newer—and higher-yielding—bonds.

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