Team Favorite At the Money: Managing Bond Duration

Summary

Masters in Business: Episode Summary

Title: Team Favorite At the Money: Managing Bond Duration
Host: Barry Ritholtz, Bloomberg Radio
Guest: Karen Vera, Head of iShares US Fixed Income Strategy, BlackRock
Release Date: January 1, 2025

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Introduction

In this episode of Masters in Business, Bloomberg Radio host Barry Ritholtz delves into the intricacies of managing bond duration amidst fluctuating interest rates. Joining him is Karen Vera, the Head of iShares US Fixed Income Strategy at BlackRock, who provides expert insights into bond performance, investor strategies, and the broader implications of interest rate movements.

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Understanding Bond Duration

[01:16] Barry Ritholtz:
"How should investors manage bond duration in an era of rising and likely soon falling interest rates?"

Karen Vera begins by elucidating the concept of duration, emphasizing its role as a measure of a bond's sensitivity to interest rate changes.

[02:33] Karen Vera:
"Duration is simply the interest rate risk of a bond. Or you can think about it, it's the amount that the price is going to change in response to a change in interest rates."

She explains that a bond with a duration of 5, for example, would decrease in value by 5% if interest rates rise by 1%. Vera also introduces more nuanced aspects like key rate durations and credit spread duration, which account for interest rate risks at various points along the yield curve and changes in credit spreads, respectively.

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Impact of Interest Rate Changes on Bonds

Barry and Karen discuss the historical impact of interest rate hikes, particularly referencing the Federal Reserve's actions in 2022.

[04:03] Karen Vera:
"We actually had in 2022 one of the worst years in terms of bond performance in decades. The AG or the aggregate index... was down about 13%... long bonds had double-digit losses."

Vera highlights that longer-duration bonds, especially those exceeding 20 years, suffered significant declines, underscoring the vulnerability of long-term investments to rising rates.

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Historical Context: The Long Bond Bull Market

Barry reflects on the unprecedented period of declining interest rates over the past four decades.

[05:16] Barry Ritholtz:
"Is that the longest bond bull market in history? Probably unlikely to ever be matched again in our lifetime."

Karen confirms this sentiment, attributing the prolonged decline in interest rates to improved central bank management of inflation, globalization, and demographic shifts.

[05:41] Karen Vera:
"No barrier, Spot on. We have seen interest rates fall and I think it's for a few different reasons... globalization... aging population."

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Yield Curve Inversion and Investor Responses

The conversation shifts to the phenomenon of yield curve inversion, a precursor to economic recessions, and its effects on investment strategies.

[06:49] Karen Vera:
"We've seen these inverted yield curves. They typically happen before recessions... We're at the point where the yield curve is still inverted."

Vera notes that this has led investors to favor ultra-short duration bonds and cash equivalents, as reflected in the significant inflows into money market funds and increased cash holdings in portfolios.

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Current Trends in Fixed Income Investments

Barry and Karen explore the current landscape of fixed income investments, especially in light of impending interest rate cuts.

[08:17] Karen Vera:
"We're seeing money market funds are considered cash equivalents... We're seeing more people wanting to add some duration."

As investors anticipate rate declines, there's a noticeable shift towards intermediate-duration bonds and bond ladders, aiming to capture yield and potential price appreciation as rates fall.

[09:56] Karen Vera:
"We're seeing some money move this fall and into 2025... when people actually notice that the rates are coming down in some of these cash-like products."

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Strategies for Managing Bond Duration

Karen offers actionable strategies for investors navigating the current and future interest rate environment.

[12:14] Karen Vera:
"If it's part of your investment portfolio and you're just seeking the highest amount of income, you should think through what are the return expectations over the next three, five, ten years and really use the opportunity to get that asset allocation back on track."

She advocates for balancing cash positions with intermediate-duration bonds to optimize returns and mitigate risks associated with rate fluctuations.

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Risks Associated with Long Duration Bonds

Discussing the inherent risks, Karen addresses the volatility of long-duration bonds and their role in portfolio diversification.

[12:56] Karen Vera:
"Longer duration fixed income paper does have almost equity-like volatility... We do see it as a very efficient hedge against equity markets."

She points out that while long-duration bonds can be volatile, they serve as a hedge during equity downturns, providing stability and potential inflows when equities falter.

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Conclusion

Barry summarizes the key takeaways for investors:

[13:42] Barry Ritholtz:
"Investors who have been enjoying 5% yields in money market and managing very short-term duration bond portfolios should recognize hey, rate cuts are coming... if you wait too long, you're gonna miss the opportunity to lock in long duration higher yielding bonds as the cycle begins."

Karen Vera reinforces the importance of proactive bond management in anticipation of changing interest rates, urging investors to reassess their fixed income strategies to optimize for both yield and risk.

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Notable Quotes

• Karen Vera [02:33]:
  "Duration is simply the interest rate risk of a bond. Or you can think about it, it's the amount that the price is going to change in response to a change in interest rates."

• Barry Ritholtz [05:16]:
  "Is that the longest bond bull market in history? Probably unlikely to ever be matched again in our lifetime."

• Karen Vera [06:49]:
  "We've seen these inverted yield curves. They typically happen before recessions..."

• Barry Ritholtz [13:42]:
  "If you wait too long, you're gonna miss the opportunity to lock in long duration higher yielding bonds as the cycle begins."

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Key Insights

1. Duration Matters: Understanding bond duration is crucial for managing interest rate risk. Longer-duration bonds are more sensitive to rate changes, offering higher yields but greater volatility.

2. Historical Context: The past four decades have seen declining interest rates, creating one of the longest bond bull markets in modern history. However, this trend is shifting with recent rate hikes.

3. Yield Curve Inversion: An inverted yield curve signals potential economic downturns, prompting investors to prefer short-term bonds and cash equivalents for safety.

4. Anticipating Rate Cuts: With expectations of impending rate cuts, investors are strategically repositioning their portfolios towards intermediate-duration bonds to capitalize on both current yields and future price appreciation.

5. Risk Management: Long-duration bonds, while volatile, can act as effective hedges against equity market downturns, providing portfolio stability.

6. Proactive Strategy: Investors are encouraged to reassess their fixed income allocations, balancing between cash, short-term, and intermediate-duration bonds to navigate the evolving interest rate landscape effectively.

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Final Thoughts

Managing bond duration in the current economic climate requires a nuanced understanding of interest rate dynamics and strategic asset allocation. As interest rates are poised to decline, investors must balance the allure of high current yields with the potential for future price gains, all while mitigating risks through diversified fixed income investments. Karen Vera's insights provide a roadmap for navigating these complexities, emphasizing the importance of proactive and informed decision-making in bond portfolio management.

Transcript

[Barry Ritholtz]

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[Barry Ritholtz]

Is on my side. Yes it is. Time is on my side. Yes it is how should investors manage bond duration in an era of rising and likely soon falling interest rates? The challenge Long duration bonds lose value when rates go up. Shorter duration bonds can also lose value, but far less. What happens when the reverse occurs when rates falls? Well, the value of long duration bonds go up. Shorter duration go up, but less. As it turns out, there are many ways investors can take advantage of of changing interest rates. I'm Barry Ritholtz and on today's edition of at the Money, we're going to discuss how to manage your fixed income duration when the Federal Reserve becomes active when it comes to interest rates. To help us unpack all of this and what it means for your portfolio, let's bring in Karen Vera. She is head of iShares US fixed income strategy for investing giant BlackRock. So Karen, let's just start with the basics. What is duration? Why does it matter? And why does it seem so confusing to so many bond investors?

[Karen Vera]

So duration is simply the interest rate risk of a bond. Or you can think about it, it's the amount that the price is going to change in response to a change in interest rates. So the nice thing is today almost any bond or bond fund will typically have that duration number published. So if the duration, for example, is 5, if interest rates go up by 1%, that bond will drop in value by 5%. So it's a pretty easy relationship to think about. I think where it gets tricky is that that's just an average for the bond or for the bond portfolio. But there's also durations or the interest rate risk at different points on the yield curve. So like two year, we call those key rate durations. So you can think of how much am I exposed to the two year point, the five year point, 10 year point, 20 and 30. And then we also have something called credit spread duration. How does the bond's price change in response to changes in credit spread or the additional yield over Treasuries? So I think when investors think through interest rate risk and how much risk they want to take, duration is a helpful measure for at least quantifying the loss that they could have from changes in rates.

[Barry Ritholtz]

So let's look at some real life examples. The Fed began raising rates in March 2022. About 18 months later they pretty much finished and we were over 500 points basis points higher. Then we began how did that impact bonds both short and long duration?

[Karen Vera]

We actually had in 2022 one of the worst years in terms of bond performance in decades. The AG or the aggregate index, which is the broad measure of the taxable bond market was down about 13% and that has an intermediate duration or duration of between five and six years. However, long bonds had double digit losses. I think 20 plus year treasuries were down over 20%. And I think that really hurtful for a lot of investors who had moved into bonds just coming off of the zero interest rate policy that the Fed adopted after Covid.

[Barry Ritholtz]

And if memory serves me, I think 2022 was the first year since like 1981 where both stocks and bonds were down double digit. Very unusual, twice a century sort of thing.

[Karen Vera]

That's right. And it really comes back to why were interest rates going up, why did stocks underperform it? And it goes back to the inflationary environment. Post Covid, inflation came back into the and the Fed needed to tighten interest rates in order to stop inflation and get the economy back on track. We had investors reacting to that and that's why we saw a year where both asset classes were down prior to.

[Barry Ritholtz]

The initiation of that rate hiking cycle in 2022. It felt like, at least for most of my adult life, going back to Paul Volcker as chairman of the Fed in the early 80s, interest rates pretty much did nothing but go down. It felt like hey, for 40 years we had nothing but on average lower rates. Is that an exaggeration or is that pretty much what took place?

[Karen Vera]

No barrier, Spot on. We have seen interest rates fall and I think it's for a few different reasons. I think the central bank Got better at managing inflation. So if inflation is lower than the absolute level of rates are lower, we saw globalization where things became cheaper, more efficient. And we also have an aging population. And in various studies we've seen that as economies age, interest rates tend to be lower because consumption behavior changes. So we had all of those tailwinds kind of pulling interest rates down over the years.

[Barry Ritholtz]

So that 40 years, as far as you know, is that the longest bond bull market in history? Or at least in US history? I don't know what happened in Japan a thousand years ago, but yeah, I.

[Karen Vera]

Think in modern, we could say modern history. I think that that is a fair statement.

[Barry Ritholtz]

Right. And probably unlikely to ever be matched again in our lifetime or perhaps our kids and grandkids. So let's talk about what started a couple of years ago. The yield curve inverted. How does that impact bond investors? If you're, if you're getting paid the same for long duration as you are for short duration, why would you want to hold long duration? Paper.

[Karen Vera]

Yeah, we've seen these inverted yield curves. They typically happen before recessions and they typically happen when the market expects short term rates to come down following a period of rates being risen higher. We're at the point where the yield curve is still inverted. And the response has been pretty amazing by investors. They've all moved into ultra short duration bonds, money market funds, bank deposits are at all time highs. In fact, even in August with a lot of the market volatility we just observed, we saw very strong flows coming into money market. So people are literally sitting in cash. And then we have some data on the average financial advisor's portfolio is about 7% in cash or ultra short term bonds which is down from over 10, 15%. So now they're sitting at 7. So we're still seeing a lot of even professional investors are keeping things in cash in response to this inverted yield curve.

[Barry Ritholtz]

So let's take a closer look at that. For a long time, investors or cash holders were getting practically nothing for a decade or so. But after the Fed brought rates up to five and a quarter, you could get 5% and change in a fairly risk free money market. What sort of competition does that create for longer duration bonds? And are money markets truly considered liquid cash? How do you categorize them?

[Karen Vera]

I'll take the money market fund question first. So we do see money market funds are considered cash equivalents. You can typically get your money back within a day, just depending on the cutoff cycle with the provider. So we see a lot of people sitting in Those cash and ultra short term investments because they are liquid and they are yielding a lot. However, we're seeing more people wanting to add some duration. So if I can get 5% today, that's great. But if the Fed starts cutting in September, December really moves that overnight rate back down into that 3% range, which is what we think it will do. Over the long term, those 5% yields are going to disappear on you. We are seeing investors building bond ladders, adding intermediate duration, because when that yield curve does start to reshape more normally, where you get the most bang for your buck is in the belly of the curve, that 3 to 7 year maturity. So not only can you lock in 4 or 5% yields there, but then you can get some price appreciation when interest rates begin to come down. That's really what we're seeing investors doing right now is moving out the curve a bit in response to the falling rate environment that's coming.

[Barry Ritholtz]

So I'm glad you brought that up. We're recording this right after the Labor Day holiday weekend in 2024. Everybody has pretty much agreed. Jerome Powell has come out and said it, hey, we're gonna begin cutting rates. The long wait is over. And you mentioned 15, was it 15 trillion. Went down to 7 trillion. In money markets, is the assumption that a lot of this is flowing into intermediate or longer dated bonds in anticipation of the Fed cutting? What is going on with all that cash moving around?

[Karen Vera]

We absolutely have seen a lot of people are still staying put. So we don't see people moving until they need to, until they actually see the rates drop on some of their money fund money market funds. But we are seeing some money coming into bond ETFs, both index funds and active funds. We're seeing more people building out bond ladders. So through term maturity ETFs such as our Ivons. So we are seeing some of the money move. We're actually looking up north to Canada. Canada's gone through a few rate cuts now and we're seeing money in that market move back into bonds quicker than in the US on a percentage basis. So I think we will see a lot of money move this fall and into 2025. I think when people actually notice that the rates are coming down in some of these cash like products.

[Barry Ritholtz]

So pardon my naivete for asking such an obvious question. If you wait for rates to fall to move into longer duration bonds, haven't you missed it? I mean, don't you want to extend your duration before the rate cuts begin? In fact, we saw rates move down appreciably in August following the most recent. The CPI data point was very benign. We've seen the restatement of labor data which says, hey, the labor market, while it's still healthy, it's much less overheated than we previously thought. It seems like the bond market is way ahead of both the stock market and the Fed. How do you look at this?

[Karen Vera]

Markets are great about getting ahead of the next cycle and we have seen that. We've seen interest rates coming down across the curve even before the Fed has moved. We think though it's not too late, you're still going to get. There's some uncertainty about how quick the Fed is going to cut, how quickly their yield curve is going to reshape. So we're even using some of these days when rates go back up a bit. Those are, those are good entry points or better entry points to come back to bonds. So we don't think it's too late. And I think that the investors could rethink their strategy today to kind of get ahead of the next wave of cuts.

[Barry Ritholtz]

So that's the perfect segue into investors who are interested in fixed income and yield. What should these folks be doing right here at the end of the summer in 2024 and heading into the fourth quarter?

[Karen Vera]

I would say think about your cash position. What are you using that cash for? If it needs to be liquid, for expenses and emergency fund, keep it there. But if it's part of your investment portfolio and you're just seeking the highest amount of income, you should think through what are the return expectations over the next three, five, ten years and really use the opportunity to get that asset allocation back on track, that stock and bond mix and move out to some of more intermediate dur. Because we think that's really where you're going to see the biggest change in interest rates. And you could get the most both price appreciation as well as still some pretty compelling income.

[Barry Ritholtz]

And our final question, how should investors be thinking about the risk of longer duration fixed income paper?

[Karen Vera]

So longer duration fixed income paper does have almost equity like volatility. It does have kind of double digit volatility. We do see it as a very efficient hedge against equity markets. So if equity markets fall, we tend to see that flight to quality and investors go to towards those long duration, especially Treasuries. We have a Treasury ETF TLT, it's 20 plus years. It actually saw the highest amount of inflows of any ETF vehicle in the month of August because people were trying to hedge some of that equity market volatility. So if you have a portfolio that's very heavy in equities, 80, 90 plus percent, you could add a little bit of long duration bonds and that would help smooth out the portfolio returns over time. So that's really the role that we think of with longer duration bonds.

[Barry Ritholtz]

So to wrap up, investors who have been enjoying 5% yields in money market and managing very short term duration bond portfolios should recognize hey, rate cuts are coming. Jerome Powell said they were coming. This cycle is likely to last more than just a cut or two. The bond market is already starting to move yields down and if you wait too long, you're gonna miss the opportunity to lock in long duration higher yielding bonds as the cycle begins. I'm Barry Ritholtz and this is Bloomberg's at the Money Time is on my side. Yes it is. Time is on my side. Yes it is.

[Hes Yu Jo]

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[Hes Yu Jo]

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