Top 10 reasons to extend duration now

When my daughter was younger and I asked her to do something she didn’t want to do, like turn off the screens or get ready for bed, she’d give a mischievous look and say, “give me 70 reasons why.” With that line of thinking, only the most obvious ideas with unlimited pros and zero cons could be supported. Inevitably, when I only had a few reasons, or if she could produce a counterpoint to any of them, I didn’t meet the “70 reasons rule” and it invalidated the idea. The bar was intentionally set way too high.

That’s a bit how the case for extending duration can feel. If you’re looking for a reason not to extend duration, you’ll have no issue finding one. Attractive returns in cash. Interest rate volatility. The inverted yield curve. These haven’t changed. But the reasons to extend are numerous. I don’t expect to hold your attention for 70 reasons. But here are my top 10.

10 - Citi surprise indices rolling over.

To start the year, we’ve had positive readings in the Citi Economic Surprise Index and the Citi Inflation Surprise Index, meaning both growth and inflation came in above expectations. The clear trend with this backdrop is for rates to rise. But these Surprise series tend to mean revert as expectations ultimately catch up to reality. In the last few days, we’ve seen the Economic Surprise turn negative, not because underlying growth has been weak, but because the expectations got too out of line, and rates fell. We might need a growth scare to drive rates down meaningfully, but normalizing growth and inflation expectations should drive rates somewhat lower. That’s good for duration.

9 - Historically attractive real yields.

The market is expecting 2.5% annualized inflation over the next five years. That means you’re getting 2% or more in real yields. We haven’t seen real yields like this since before the Global Financial Crisis. These attractive real yields can be found in short duration fixed income as well, but if rates fall and you’re in cash or short duration, you’re reinvesting into a lower rate environment. By extending duration you can lock that in.

8 - 2022-itis.

Scarred by 2022 losses, the market is still worried about a right tail inflation outcome. Derivatives contract pricing shows investors still think 4-5% annualized inflation over the next five years is plausible. Inflation will eventually get to target – it’s just taking the scenic route. This is contributing to an attractive term premium, or the return you get for taking on duration risk over and above the expected path of cash over that time. You’re getting paid extra to take on inflation uncertainty risk because others are afraid to.

7 - The Fed is about to slow Quantitative Tightening.

The Fed is letting up to $60 billion In Treasuries roll off their balance sheet each month. In June that’s being reduced to $25 billion per month. The Fed was a marginal buyer of bonds in QE. In QT, the absence of that marginal buyer put upward pressure on yields and downward pressure on prices. With slower and steadier QT moving forward, we could see the buyer return as the Fed winds down the balance sheet more slowly. This should also reduce the risk of volatility in Treasury markets.

6 - Equity risk premium close to zero.

The 12-month forward earnings yield on the S&P 500^® is around 5%. The yield you can get on Treasury bonds is slightly lower than this, or, if we’re talking about corporate bonds, even higher. Equities are much riskier than bonds and tend to carry a return premium that’s much more significant. An equity risk premium near zero means that the relative value between stocks and bonds favors bonds, and if you have a time horizon of greater than a couple of years, you should tilt your portfolio in that direction.

5 - Large institutional buyers getting back in.

Public pensions are showing increased interest in bonds. Many municipalities set asset allocation targets with the goal of earning 7 or 7.5% with as little risk as possible. When bond yields were 2%, we saw record high equity and private market allocations. Now that bond yields have moved into the 5% range, several large pension plans have reduced their equity targets and increased their target to fixed income. It’s not just the price-insensitive institutional investor doing the bond buying. It’s the price-sensitive investor too.

4 - Stock/bond correlations rolling over.

If you’re using bonds for equity risk offset, then you care about stock/bond correlations. Bonds do a great job diversifying stocks in a growth scare and a bad job diversifying stocks in an inflation scare. Part of the reason correlations have been elevated is we haven’t actually had a growth scare. When economic growth data says “boo” investors say “bonds.” That’s good for diversification.

3 - Yield advantage over other countries.

There are at least 25 countries with lower 10-year government bond yields than the US. Essentially all the other developed countries in the FTSE WGBI – plus seven emerging market countries. In some countries like Germany, local investors can buy Treasuries, pay to hedge back to their local currency, and still end up ahead compared to if they bought their own country’s debt. This helps put a ceiling on US Treasury yields.

2 - Favorable scenario analysis.

Over the course of a year, bond returns equal starting yields plus price return. The starting yield part is easy; forecasting the price return is harder. Using our Investment Committee’s macroeconomic roadmap, a yield curve proxy for each regime, and the probabilities we assign to each outcome, the weighted average return is attractive for bonds, and very attractive for long duration.

1 - Strong environment for active management.

With tight credit spreads, you don’t want to own everything. Active managers can add value by finding relative value along the yield curve, avoiding securities with asymmetric payoff profiles, and of course, quickly deploying dry powder if the opportunities present themselves. This also allows you to add duration to your portfolio in a more diversified way. Yields don’t often move in unison across fixed income. Active management in duration-sensitive strategies allows you to walk that tightrope where you’re being defensive but also not missing out on opportunities.

The bottom line

This isn’t a case for long duration over short duration. It’s a case for both. There are lots of reasons not to extend duration, but these short-term tailwinds and the benefit of added downside protection over the next several months shouldn’t be dismissed. Certainly time horizon matters. The role of fixed income in your portfolio matters. And your starting point matters. But if your duration is under 4 years, or if you still have a sizable cash allocation, you very well might want to reconsider your approach. And avoid falling victim to the “70 reasons rule.”