Does Shorter Duration Pay Off When Interest Rates Rise?

September 07, 2018

With the Fed poised to further raise rates this year as well as next, it is insightful to investigate how a bond’s duration can impact its return in a rising interest rate environment. Typically, a bond’s duration is used to gauge its price sensitivity to changes in interest rates. As most investors know, bond prices are inversely related to interest rates; the longer the duration, the greater the sensitivity to interest rate movements. In the event of rising rates, all else equal, a bond with a higher duration will decline more in price.

As a simple illustration of how duration can affect bond prices in times of rising interest rates, we compare the performance of short bonds — measured by the Barclays 1–3 Year Govt/Credit Index — and long bonds — measured by the Barclays Long Govt/Credit Index. At this point, the Federal Reserve is likely to announce two more interest rate hikes in 2018, with each hike expected to be 25 basis points. The respective durations for the two indices used in the analysis are approximately 1.9 and 14.9, respectively. Assuming a parallel shift in the yield curve and keeping other economic variables constant, the index values will decrease by 0.95% (short bonds) and 7.45% (long bonds), given the 0.5% increase in interest rates by the end of 2018. If this is true, does this mean that short duration bonds always outperform long duration bonds when interest rates goes up?

On average, the annualized cumulative return over seven interest rate rising periods since 1976 on the Barclays 1–3 Year Govt/Credit Index is 4.69% and 3.4% for the Barclays Long Govt/Credit Index. The correlation with interest rates is also consistently high for short duration bonds at 87% as opposed to 24% for long duration bonds.

At this point, the numbers suggest that short duration bonds tend to outperform when interest rates rise. However, the last two periods in the chart show the opposite trend — long bonds have actually outperformed their shorter duration counterparts. How so? A primary reason is how the shape of the yield curve changed during the last two interest rate increases, as not all rate increases are parallel shifts of the entire curve. The shifts in the yield curve for the periods 1994–1995 and 1999–2000 were indeed parallel whereas the last two periods featured rises on almost exclusively the short end of the yield curve. Rates were anchored on the long end during these periods due to demand from foreign investors looking for greater yield than offered by their home countries, particularly in Europe and Asia.

Overall, the chart shows that short duration bonds provide a more predictable return when rates rise, however a non-parallel shift in the yield curve can influence their relative performance vs. longer duration bonds. For institutional investors, if nothing else this serves as a reminder that trying to time interest rates and changes to the shape of the yield curve is an utterly difficult task to consistently get right, so investors are best served maintaining and re-balancing their bond allocations as dictated by their investment policy statements.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.