Duration risk looms over global fixed income portfolios

Duration risk is currently being viewed by analysts as one of the primary threats to fixed-income portfolios globally, with many potentially taking on this risk without realising it. The risks are rising as yields on government bonds worldwide tumble to record lows and, in some cases, negative territory, forcing investors to turn to longer-dated bonds to maintain required levels of returns. However, MarketWatch highlights that the problem is unsuspecting bondholders may be shocked by the size of the hit to returns when interest rates rise.

In a world where over $10 trillion in government debt sport negative yields, desperate investors are running out of options to ensure even meager returns. As a result, they may be taking on a big risk without even realizing it.

Most investors, for example, understand that buying junk bonds, which have low credit ratings in exchange for higher yields, involves taking on more risk.

But talk about the risk of extended duration and “most retail investors won’t even know what that is,” said Kathy Jones, chief fixed-income strategist at Schwab Center for Financial Research.

Yet duration risk has been growing fast across the world and is now cited by analysts as one of the main risks threatening fixed-income portfolios—with BlackRock’s strategists going as far as calling it one of the reasons that makes the current bond market riskier than the market that preceded the so-called taper tantrum in 2013.

In short, duration measures how much bond prices change in response to a change in yields (debt prices rise as yields fall and vice versa).

The risk has become more pronounced as government bonds around the world tumble to record lows and, in some cases, negative territory. That forces investors to buy longer-dated bonds to maintain necessary levels of returns. The danger for unsuspecting bondholders, however, is that they could be surprised by the size of the hit those returns take once interest rates start to rise.

The average duration of Barclays U.S. Aggregate Bond Index was 5.54 on Tuesday, slightly higher than the 10-year average of 4.93.

But the absolute number doesn't tell the whole story. As the following chart shows, duration has in fact been on a constant rise over the past several years, recently reaching a one-year high and approaching its highest level in a decade.

Schwab Center for Financial Research

So, duration is a complex measure that estimates just how much bond prices will change as the yield rises or falls. For example, the price of a bond with a five-year duration would fall by 5% if its yield went up 1%.

Overall, the longer the maturity of a bond, the longer the duration and the higher the duration risk. For instance, according to one calculation, for a 20% drop in price, it would take a 250-basis-point rise in the yield of a 10-year bond but only a 75-basis-point rise in the yield of a 50-year bond. One basis point is equal to one hundredth of a percentage point.

Things get even more risky when yields are already at historically low levels, Jones said, as even a few-basis-point move in a bond that is yielding near zero could be a significant change, sending its price plummeting.

Yields have dropped around the world—with the 10-year Treasury yield TMUBMUSD10Y, 3.777% falling last week to a nearly four-year low—as investors flocked to government debt amid a global flight to quality fueled by central-bank stimulus, jitters about a potential U.K. exit from the European Union and widespread worries about slowing economic growth.

The government bond rally has brought many benchmark yields to record lows and even negative territory, most notably the 10-year German bond yield TMBMKDE-10Y, 2.391% known as the bund, which spent three sessions in negative territory last week for the first time in history. In Switzerland, the yield on the country’s 30-year bond turned negative last week for the first time ever.

As yields tumble, life-insurance companies and pension plans that have specific long-term liabilities to fund “simply cannot meet their assumptions,” said Mark Travis, chief investment officer at Intrepid Capital Funds.

There’s a “disconnect between price and value,” according to Travis, both in the bond market where prices are skyrocketing as yields are tumbling, and in the equity market SPX, +0.43% , where stocks are trading at frothy valuations.

This leaves investors with no other option than to either buy weaker credits—which might not be permissible for certain insurance and pension funds—or buy longer-dated bonds, which means taking on more duration risk.

But the higher risk doesn't come with higher returns, BlackRock’s interest-rate strategists cautioned in a report released last week.

Quite the opposite, the risk-return trade-off is getting worse, as “investors are forced to take on greater levels of risk for diminished reward potential,” the strategists argued.

As the following chart shows, yields (on the y axis) have been falling but duration risk (on the x axis) has been growing.