As Mike Booker mentioned in the Q4 newsletter, we think bonds still deserve a place in most portfolios. After all, bonds are ultimately one of the greatest diversifiers an investor can own. Historically, conservative investors have allocated large percentages of their portfolio to bonds because of their low volatility and consistent positive returns. They’ve actually done quite well over the decades. Our fear, however, is that some bond-heavy portfolios may hold more risk than people realize.
The particular type of risk I’d like to talk about is called Duration Risk. Without realizing it, investors have been adding duration risk to their portfolio.
Duration of the Barclays US Aggregate BOND INDEX (in years)
Duration is a measure of how sensitive a bond is to changes in interest rates. As you may already know, the price of a bond decreases when interest rates go up. The higher a bond’s duration, the more it stands to lose if interest rates go up. For instance, if interest rates were to increase by 1% a bond with a 2 year duration would decrease in value by 2%. Likewise, a bond with a 5 year duration would decrease in value by 5%, and so on. Over the last 10 years, the average duration of the bond market has steadily increased from 3.5% to over 5% (see chart above). With interest rates likely on the move, we think this is a risk that conservative investors should consider carefully.
Bond investors need to understand duration risk more than ever before. Here’s why… Most traditional bond mutual funds are handcuffed by their prospectuses to maintain a duration closely tied to a benchmark. The duration of the most widely used bond benchmark is currently slightly above 5% (the Barclays US Aggregate Bond index). That means most core bond funds are contractually obligated to have a duration of about 5% even if they’d prefer to hold less duration. The share price of these bond funds could drop substantially if interest rates were to move higher.
Last year, we decided to move the majority of our fixed income portfolio to talented managers that have the flexibility to minimize duration risk when appropriate. They’re not tied to any particular index. Currently, all of the new bond funds in our portfolios have chosen to keep their durations much lower than the overall bond market. Interestingly enough, all three of these funds made money last year even though the Barclays Aggregate bond index lost over 2%. These managers have proven, long-term track records and we are confident in their ability to navigate what could be a choppy bond market for the foreseeable future.
-Heath Hightower, CFP®
Sources Used: Morningstar Workstation®, Blackrock® “Rethink Your Bonds” whitepaper as of 9/30/13