80-20 Investor  

The importance of bond duration

This week I want to focus on a DIY investing lesson which will shed a lot of light on the current bond market sell-off. It will also help you to understand why bonds react badly to good news about the economy, as they did this week. The key principle I'm going to talk you through is something called bond duration.

When you invest in a bond you receive a fixed series of income payments and a final return of capital (at the end), in exchange for your initial investment. It is essentially a loan from you to a company or government.

Now in a simple case of where you don't receive interest payments (called coupons) on the loan (bond) and instead just receive your capital amount back at the end of the agreed term, let's say 10 years, it's pretty easy to work out when you will be repaid your money. In this example the amount you are repaid will equal the amount you initially invested (loaned) when the bond matures in 10 years time as that's when you are repaid.

Yet with most bonds you do in fact receive regular coupons (interest payments) periodically until the end of the bond term when you then receive the lump sum. These coupons compensate you for the investment risk you are taking. Now the point at which you have been repaid the initial amount you paid for the bond is not 10 years but somewhere much earlier. The point in time depends on the amount of interest (coupons) you receive. 

That length of time is actually called a bond's duration and obviously differs from the bonds ultimate maturity date. Now if a bond has a low duration it means that the income stream for the bond is front-loaded so you get back your money much sooner than the final capital repayment at the bond's maturity date. By contrast a bond with a long duration makes you wait until much later to get to the break even point. 

The other key thing to remember about a bond is that the coupon is usually fixed. So if you have a bond that lasts 20 years then the annual payment you receive will be the same for each of those 20 years. Of course that means that as interest rates rise in the economy, or inflation increases, the real purchasing power of your future coupons becomes a lot less. Therefore if you wanted to sell the bond on you are going to get a lower price for it as it's less attractive to any potential investor. So now you know why rising interest rates and inflation are bad for bonds and bond funds. Given that rising interest rates and inflation happen in growing economies that's why every time you hear about a surprisingly good bit of economic news your bond fund falls in value.

What dictates how much your bond fund falls in value is where duration comes in. The scale of the fall is influenced by a bond's (or bond fund's) duration. If it looks like interest rates won't stay low forever and central banks will start pushing them up then bonds with a longer duration will see the real value of their income stream hit the hardest. By contrast if you had a short dated bond that matured in six months then a rise in interest rates will have little impact on the spending power of any income you've yet to receive or the final repayment.

So you can now see why for every 1% increase or decrease in interest rates, a bond's price will change by roughly 1% in the opposite direction for every year of duration it has. So if a bond has a duration of 5 years then if the interest rate rises 1% the bond price will fall 5%. Bond funds own hundreds of bonds which when combined give the fund an overall duration which fund managers will look to control.

So why am I telling you all this? It's because it helps explain why the sell off in bonds has been relatively sudden and severe and why some bond funds are taking more of a hammering than others.

In a world where interest rates are artificially low because of central bank policy bond investors have been searching for yield ever since. It means that they have been taking on more duration risk and buying longer and longer dated bonds. To show how crazy things have become Belgium's Government issued a 100-year bond earlier this year with a duration of 47 years. That is enormous. By contrast the average global bond index fund has a duration of nearer 7 years which is still high by historical standards. 

The point is that the bond market is now so skewed towards the assumption that global growth will remain anaemic and interest rates low for the foreseeable future that holding long duration bonds is a crowded trade. Yet in the last few weeks the market has suddenly become gripped by fear that central banks won't keep rates artificially low much longer or keep buying ridiculous amounts of bonds via QE. 

The fear that rates will soon start rising has a similar impact on the bond market as the actual event would have because markets have moved to reprice everything. The pent-up duration risk in investors' bond holdings means that we've seen the prices of certain long dated bonds and Government debt plummet as yields have spiked. In fact bonds are heading for their worst week in three years.

The chart below perfectly demonstrates how this current bond sell-off has not only intensified since last week but is also not universal. Those long-dated bond funds (which also tend have longer duration) have fared the worst while short-dated bond funds (with shorter duration) have barely moved. In fact as the chart shows some have even made money.

You will likely start to hear commentators talk about bond duration in the coming weeks yet most investors and financial advisers still have no idea what it really is. If you have managed to stay with me so far in this newsletter you have understood one of the most complex ideas in bond investing.

If the sell-off intensifies further (it has now spread outside of the UK) then funds with long durations will get hammered. The answer is to look to hold bonds with shorter durations. Yet not everything in life is simple. That's because shorter-dated bonds are often much more volatile. The other problem for investors is that it's not easy to find out a fund's duration let alone find out an average for the sector as the data is just not publicly available.

For 80-20 Investors when/if things unravel further the algorithm will inevitably highlight those funds worth looking at. Of course if the market's view on central bank policy changes along with their view on global economic growth the bond market could well bounce back. 

As for equities, often where the bond market leads equities tend to follow. 

Your insights

Just this week I answered a question from one of you in this month's Chatterbox on how a bond fund had a greater Max Weekly Fall figure in the data tables than an equity fund. You can read my answer in full via the link above, however, after reading this week's email you will know the short answer is.....Duration.

Interestingly in my answer to another recent question regarding investing in funds with labels such as 'Recovery' I mentioned that fund houses often jump on the latest bandwagon and launch funds they think will sell (The article was called Funds for a market bounce). Unsurprisingly fund houses are now rushing to launch short dated bond funds. There have been a number launched this month alone, in the hope of taking advantage of those bond investors fearing a bond bear market.

It just goes to show how insightful your questions are and that you are noticing things which open up the world of DIY investing for the benefit of all 80-20 Investor members. So please keep the questions coming.

Data Update

As the 1st of November is on Tuesday I will publish a brand new Best of the Best Selection along with the Best Funds by Sector tables then.

Best Wishes
Damien Fahy
80-20 Investor & founder

Damien is regularly quoted in the national press including:
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