The financial crisis and the resulting market shocks had a number of surprising consequences, most of which continue to dominate headlines. One that was particularly important to bond investors, though, was the degree to which diversified bond funds struggled or lost money, even though cash flowed to Treasury bonds. Take the long-term government and long-term bond categories. Most of the time the funds in these two groups are expected to have pretty similar risks--they both focus on bonds with long maturities and relatively high-quality debt. Yet the divergence in their 2008 performance was breathtaking: The average long-term government fund gained nearly 28%, while the average portfolio in the long-term bond category--funds that hold mostly nongovernment investment-grade bonds--fell by more than 3.7%. Why?
In 2008, when investors the world over piled into Treasury bonds--and almost exclusively Treasury bonds--long government-bond funds were the beneficiaries. Other long-term investment-grade bonds and funds were not similarly rewarded. Fears about the broad economy and the very future of the financial sector prevented nongovernment funds from rallying.
Under normal circumstances, portfolios' effective durations would have provided guidance about how those funds would respond to Treasury market shifts. Funds in both categories have occupied a wide range of duration territory, but nothing about the dispersion of their durations would have suggested such an extremely broad span of returns. And if that weren't odd enough, a nearly inverse phenomenon occurred as the market snapped back in 2009.
Clearly, this behaviour isn't captured by the customary risk measure for Treasury funds. The primary reason is that duration--some have taken to calling it interest-rate duration--works best for bonds that are similar. Duration will normally provide an accurate picture when you're comparing prices on the same types of bonds. In other words, if you're using changes in Treasury bond yields as your reference, they're going to have the most predictive value for other Treasury bonds. And under normal circumstances, a typical duration calculation will also work pretty well for investment-grade corporate bonds whose yields aren't too far away from their comparable Treasury counterparts, say within 2 percentage points. Once you get much farther away than that, however, the measure begins to lose its predictive value as a gauge of how much movement your bonds will see relative to Treasuries.
That kind of risk can, however, be evaluated by a measure called spread duration.
Instead of estimating how much a bond will gain or lose based on changes in Treasury yields, spread duration describes how much a bond's price will move if there's a change in the gap between its yield and that of a comparable Treasury. Spreads on the Barclays Capital Investment Grade Corporate Bond Index widened to more than 640 basis points in December 2008, from around only 100 in February 2007. If you were looking at a corporate bond with five years of spread duration, for example, that might not seem especially long. If the company hit a rough patch during normal times and its yield spread over Treasuries widened by 300 basis points (or 3%), the bond would be expected to lose 15%. Assume the kind of spread widening experienced during the financial crisis, though, and the bond would have lost nearly twice that.
Regardless of what you're measuring, though, it's important to be mindful that duration, like almost any other measure, comes with some caveats.
1. Duration is an estimate. It's designed to help you understand how much a bond's price will rise or fall given a sudden change in market yields. Even under relatively "normal" conditions, though, a bond's price may not move exactly as its duration predicts.
2. Portfolio durations are just average. The duration of a fund portfolio consists of the weighted average of the durations of its underlying bonds. Those bonds usually have very different weights and maturities, so the gain or loss predicted by duration will be most accurate if market yields change the same amount for every bond along the maturity spectrum. Such a situation is rare, though. In fact it's possible for some rates to rise while others fall (a yield-curve twist). In that scenario, two different funds with the same average duration could perform differently.
3. Read the fine print. To understand your bond fund better, dig into its most recent portfolio report and try to figure out what it holds (or ask your financial adviser to do it for you). If you find things that you don't recognise, like interest-only mortgage CMOs or inverse-IOs, for example, look for a clear explanation in your fund's reports or pick up the phone and call the fund company. While the story in 2007 and 2008 was mostly about credit, the late 2010 and 2011 story could be about interest-rate risk and mortgage derivatives. The aforementioned IOs and inverse-IOs have performed very well over the past year, but managers are in some disagreement about their valuations today. And given how volatile those complex derivatives can be if short-term rates and/or prepayments shift notably, you'll want to make sure you're comfortable with what you own.
In short, duration--or interest-rate duration--can be a useful indicator for estimating the interest-rate risk of bonds that closely track the Treasury market. Any time you deviate from owning Treasuries, you get paid more yield and perhaps get a better longer-term total return (perhaps). But you assume more and different risks, and tracking them all becomes more complicated. It therefore makes sense to use duration with some caution--and to make the effort to know what's in a fund's portfolio, rather than relying on duration or any other single number or grade when evaluating its suitability for your portfolio.
Eric Jacobson is Morningstar's director of fixed income research and an editorial director for mutual fund content.
