Basic Primer on Bond Duration and Management
Duration. Bonds. Boring. Most people I know hit the snooze button about ten extra times and then going back to sleep before fixed income class. I mean really, how could you not? Bonds are a snooze fest much of the time and require all kinds of weird math and numbers. Then there are these stupid concepts like convexity and duration combined with the fact they move in opposite directions of interest rates.. it's enough to make your head spin at first. Most of you might ask, what is the point? Well, if you've ever wondered how duration plays into managing a bond portfolio I hope I can shine a little bit of light on it for you.
Duration is a measure of the volatility of a bond to interest rates. Naturally, if you want to take on risk in a bond portfolio you extend out thus taking on more duration. The higher your duration is the great sensitivity you have towards interest rate risk. Naturally, the last thing you want to be doing is extending duration in the middle of a sell off. If you're worried about rates rising you keep things nice and short. That not only allows you to avoid larger capital losses but should allow you to quickly re-invest at the higher rates as maturities roll off. If you're not familiar with duration think of it like the beta of a stock. The higher it is, the more it will move relative to the market. Same idea. So If I have a duration of 2 I can reasonably assume that my bond will move 2% for a 100bps move in rates.
Now, depending on your needs you need to figure out whether you want to ladder out your portfolio or go at it bar bell style. Bar bell is exactly as it would seem, with two weighted ends and few maturities in between. Laddering a very standard approach where you diversify across different maturities, with something always rolling off helping to mitigate your reinvestment risk. The issue with either of these in this environment is you simply aren't getting much value anywhere. Everything is expensive really, and most of the time your just using back-ups in rates to jump in and focus on capital gains rather than worrying about the income stream.
Another point to make is when your managing against a benchmark, out performance is fleeting in this environment. Imagine your benchmark has a duration of 1.5 which is your neutral setting. You'd then target your duration to a percentage of that benchmark and manage it accordingly. If it's made up of treasuries, you might go out and run your portfolio at 98% of benchmark duration and try and outperform by trying to pick up value in other types of securities. You could go out and buy muni's or agencies to out perform your benchmark. In an environment like this we are talking outperformance measured in bp's. Corporates, actually, are one of your best friends for this.
Just to note, this is mainly regarding bullets rather than any option able bonds. Naturally, when you add callables or some such to the mix you now add volatility and other types of calculations, which while interesting, are better left for another time.
Beta is an empirical measure that someone can calculate in 4 seconds, duration is based on a complex pricing model that requires PhDs to put together properly. High beta bonds don't necessarily have the highest durations.
given that many people agree Bonds are expensive right now (yields abysmal), where do you thing is a better place for risk / reward profile that is similar to bonds?
you mentioned "corporates", but you referring to high yield paper? any corporates in particular? how would you trade this?
Thanks!
Personally I like stressed (rather than distressed) names that have been sold down to the 60s and pay about 16% YTM.
Cant see much value in buying highly rated corporates either,
I can't really fathom who is buying gilts,bunds and treasuries at the moment - they are betting on deflation and 'fighting the fed' and at some point are going to get hurt badly. There is going to be a lot of private investors nearing retirement whose shitty pensions are going to be loaded up with this crap and very soon its going to get double-fucked (technical term).
Going, I agree with you and I probably should not have attempted to equate the two. I was really only trying to illustrate what your getting when you see a duration number and a way to think about it if your not used to fixed income. Probably not smart in retrospect.
In regards to corporate stuff, I'm mainly referencing Investment grade but it is interesting watching people slowly lower their standards to try and pick up yield across the board. Whenever a decent name issues something nowadays you'll see it crazily oversubscribed. It is just extraordinarily tough to eek out any value especially when you only get tiny allocations on anything. Moreover, it really becomes a game of how low your willing to go and whether you can hedge the risks of exposing yourself to lesser credit quality. Look at agencies you'll see spreads tightening again because of the wind down announced not long ago and value is being sucked out pretty quickly. You can probably get your hands on some decent muni's that are tax exempt but the worry now is that should rules change suddenly your left holding a tax exempt muni that isn't anymore. Though, if they don't change the rules there certainly that could provide some pickup over treasury bullets of similar nature. The other place to look is ABS type stuff, mainly mortgages can provide some value but they take a ton of due diligence to figure out what on earth your exposed to. Problem now is that if you try and grab some agency MBS they have rallied away from you and have performed strongly thanks to the Fed.
Sorry, that was a little more than you probably wanted Pat but If your simply trying to pick up yield without increasing your risk profile significantly it becomes a question of bargain hunting or calling in a few favors. IMO, your best off trading the ranges because It would take something extraordinary to push, say, the 10 year outside of 2%. Honestly, the risk/reward on bonds is asymmetrically skewed to the downside in the long run. At some point rates will rise and it's more a question of who is faster or lucky enough to be short bonds when it happens. Really, the only choice your left with if your not willing to reach down into junk or lesser creditworthy instruments is to hold your nose and go out the curve as far as you can tolerate, and trade the ranges as you go.
To the best of my knowledge, duration is essentially the bond version of delta whereas convexity would be gamma
Reasonable estimate. Just remember the relationship is not linear.
Ex. Rates move up 500bps, your bond's value will not decrease by 10%. (Though for smaller 100bps it's probably pretty accurate.)
I think another good way to think about duration and convexity is that duration is the first derivative of the price-yield (a k a price-interest rate) relationship. Convexity is the second derivative.
if you hold a security for its duration, you will realize your expected return.. if you hedge your duration properly your investment will be unaffected by changes in interest rates because you break even based on your reinvestment returns
if that makes any sense
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