Why everyone's talking about… active duration

In the 2024 bond market, a passive strategy that simply aims to match the market index with minimal trading, no longer cuts it. With uncertainty over rates and inflation creating plenty of turbulence, active duration management has become a necessary way of thinking about bond investing.

Uncertainty over rates and stickier than anticipated inflation has created plenty of uncertainty in the bond markets, leading many bond investors to turn to active duration management - the careful monitoring of the market and buying and selling assets to maximise returns.

To understand why, you first need know about the end of ultra-low central bank interest rates, the decline of Silicon Valley Bank (SVB) and the persistence of memory. Fundamentally, you also need to understand duration.

What is duration?

Duration is a measure of an asset’s sensitivity to moves in interest rates. Typically associated with the bond market, where most assets have a finite maturity date, it has increasingly been used in relation to equities too.

Expressed in years, it shows investors just how much value an investment will gain or lose should interest rates go up or down. In simple terms, the value of high-duration assets will fall significantly if interest rates go up and vice versa.

Duration is closely related to the maturity of the bond – when the face value of the bond is due to be repaid in full. Bonds range from short maturity – typically 1-3 years – to long maturity – 10 years or more. Bonds with maturities between three and ten years are referred to as medium term bonds.

But while duration is closely related to maturity, and is also expressed in years, it is not the same, because it takes other factors into account – crucially the current market value and rate of return on the bond. The coupon (the fixed payment made on a bond) and the yield (the value of that coupon as a percentage of the bond’s market price) are therefore key elements in calculating duration.

The other key factors used for calculating duration are any ‘call’ features associated with the bond. A call feature is a contract clause that allows the company that issued the bond to pay it back in full before the maturity date.

Duration combines a bond’s maturity, coupon, yield and any call features. The higher a bond’s duration the more sensitive its value will be to interest rate changes, while a low duration bond is less prone to rise or fall in value in response to interest rate changes.

For example, a bond with a long maturity (say 10 years) and a modest coupon will be more sensitive to interest changes. Firstly, because the relatively low returns paid on the bond become less attractive if interest rates rise because better value may be available elsewhere and secondly because the date when the face value of the bond will be repaid is further away.

Meanwhile, bonds with short maturities and higher coupons have the lowest duration and are less sensitive to interest rates. A high coupon may still be competitive, even if interest rates rise, and the face value of the bond is due to repaid sooner.

Why was 2022 a significant moment for bond markets?

As inflation surged in 2022, major central banks hiked rates at the fastest pace in two decades to tackle it. Investors, many of whom have spent their entire careers in a world of ultra-low interest rates, suddenly had a brand-new macroeconomic indicator to worry about.

And so, after more than a decade of near-zero rates in developed markets – where a view on interest rates wasn’t really required – all bets were back on. Cogent arguments could once again be formed not only for why rates could go higher, but also for why we might see cuts.

Inflation may have eased since then, but the path forward for interest rates remains somewhat opaque.

How did the collapse of SVB in 2023 impact duration?

Bond markets endured significant volatility in 2023 amid great uncertainty about the path of interest rates, which had already risen to their highest levels since the Global Financial Crisis of 2007-2008.

In March 2023, a sharp rise in bond yields – a fall in their market price – was swiftly followed by a crisis at several large banks, led by Silicon Valley Bank (SVB), which together fuelled the nervous state of bond markets. Duration management, or rather the lack of it, was a key factor in SVB’s collapse. Withdrawals by its start-up clients, who were facing their own financing difficulties, forced the bank to sell long-term bonds.

Therefore, SVB and other investors with high duration risk were placed under huge pressure. This was worsened for those investors without a hedging strategy in which other investments or financial contracts are in place to help offset any fall in value other investments.

The volatility became self-reinforcing, too. Many investors who were sensitive to short-term price movement stopped investing in bonds or, when they could, sold down their holdings. The effect was extremely painful for many investors. For SVB it was fatal.

As a result, many institutions began adopting what is known as a ‘barbell strategy’. Such an approach focuses investment at each end of the maturity spectrum – short and long-term bonds – with little or no investment in the middle of the range. This combines exposure to short-term rate fluctuations with exposure to higher-yielding long-term bonds.

Active management of the portfolio is crucial to the barbell approach which requires ongoing reinvestment as short-term bonds reach maturity.

What lessons can we learn for 2024?

The return of higher interest rates, combined with a lived experience of just how high the stakes are should duration management go wrong, has shown bond investors the importance of taking a more active role in managing their exposure to interest rate risk.

In late 2023 and early 2024, the consensus was that inflation was tamed and central banks would make multiple interest rate cuts over the coming 12 months – some commentators were pricing in as many as six rate cuts this year.  While inflation has receded in major markets since the highs of 2022, it has not hit target levels. And there remains a wide spectrum of views about what central banks are going to do.

Adding to the uncertainty is the divergent path of inflation and rates between major economies. Inflation has fallen faster in Europe than in the US. As a result, the European Central Bank is widely expected to begin rate cuts this summer, while the Federal Reserve is signalling that US rates will stay higher for longer.

Should inflation begin to rise in the US, moderate rises are distinctly possible. In such a scenario the impact may be more significant for high yield bonds compared to investment grade bonds. Investment grade refers to bonds issued by companies that have been given a high credit score by credit rating agencies and are regarded as very unlikely to default on their debts.  The lower risk associated with these bonds means they typically pay lower returns.

In contrast high yield bonds are those issued by companies with a lower credit score. The risks of default on these bonds are regarded as being higher and so investors taking that higher risk earn a higher return.

For bond portfolio managers, active management of duration is therefore still a crucial factor: a bond portfolio with high duration may see greater volatility. In the short term, the portfolio may fall in value, reducing profits or incurring losses if bonds are sold in the near term.

At the same time, yields on bonds have risen in the higher-for longer interest rate environment, meaning that while their value may be less certain, the income they generate is higher. For investors who can afford to hold bonds for longer or even to maturity, higher duration poses less risk as they are unlikely to sell bonds in an uncertain market.

Managing duration in the months ahead will therefore require a clear understanding of investor objectives, notably their investment horizons and whether they need their bond holdings to be saleable to cover known or potential liabilities.

With the possibility that interest rates and therefore duration risk may diverge between the US and Europe, active and agile management of bond investments becomes ever more important.