How Holding Duration Is Risky during Rising Inflation
Duration is fraught with risk
In the previous article, we looked at the views of the Janus Asset Allocation team regarding equity sectors and how they may react to a rising inflation environment. Moving on to the fixed income space, the Janus team sees holding duration in portfolios as a risk.
Duration measures the interest rate sensitivity of the price of a bond (AGG) (BND). The higher the duration, the more sensitive its price is to a change in interest rates.
Janus believes that inflation is set to rise going forward. When inflation rises, a central bank stands ready to take policy actions to ensure that inflation doesn’t spike and remains within the bounds of their target level, if any. The US Federal Reserve aims to keep inflation at a 2% rate in the longer term. It prefers PCE (personal consumption expenditure) inflation to other measures of inflation like CPI (consumer price index) or PPI (producer price index).
As outlined above, longer duration is more sensitive to a change in interest rates. Thus, the Janus team says it sees risk in holding duration. The team believes that it’s time for fiscal stimulus to take over from monetary stimulus. In its August note titled “Is Inflation Bubbling Below the Surface,” the team stated, “The increase in fiscal stimulus that would give the Fed cover to raise rates, will likely lead to investors rapidly exiting the most interest rate sensitive segments of their bond portfolios.”
For actively managed mutual funds, an increase in interest rates would mean a reduction in duration, until they target a specific duration. Among ETFs, there are some that are tied to a duration, like the iShares 20+ Year Treasury Bond ETF (TLT) and the iShares 7-10 Year Treasury Bond ETF (IEF). When interest rates are on the rise, investors are quite likely to move to shorter duration funds like the iShares 1-3 Year Treasury Bond ETF (SHY). This trend could be seen among high grade (VCSH) (SCPB) and high yield (SJNK) corporate bonds as well.
A rise in inflation would also make inflation-protected bonds and instruments like the iShares TIPS Bond ETF (TIP) attractive.