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Defensive fixed-income tactics: Watch your duration

Wells Fargo Investment Institute - April 26, 2021

by Peter Wilson, Global Fixed Income Strategist

Key takeaways

  • As interest rates have fallen over the past decade, the durations of many investor benchmarks have been quietly lengthening, including for some credit indices where sensitivity to interest rates might not be expected to be the dominant influence on returns.
  • With U.S. Treasury yields expected to rise further, we believe investors should pay attention to the duration of their bond holdings. An analysis of returns in the first quarter of this year confirms that duration has been a key determinant of returns.

What it may mean for investors

  • As part of our more defensive stance within fixed income, we prefer the intermediate sector within high-credit-quality taxable bonds. We view U.S. high yield as worthy of inclusion in a reflationary environment, as the shorter duration of this market makes it less sensitive to rises in U.S. Treasury yields. U.S. dollar-denominated emerging market (EM) corporates may prove more defensive than sovereigns.

Duration and interest rates

Duration is a popular metric used by bond investors. Like years to maturity, duration is a measure of how long an investor has to wait to receive cash flows associated with the bond. But duration is a more useful indicator than the simple life of the bond (or bond index, or portfolio), since it also allows the investor to gauge the sensitivity of the bond or the portfolio total return to a move in yields.

To clarify by way of a simple example, the duration of the current 30-year U.S. Treasury bond is around 22.5 years. The duration of the 5-year note is just 4.9 years. This means that if yields on both securities were to rise by 1%, then the holder of the 30-year bond might expect losses in the order of 22%, more than four times as much as the holder of the 5-year note.

Over the first quarter of 2021, the yield on the 10-year Treasury note rose by 83 basis points (0.83%) and the 2-year yield by just 4 basis points (0.04%). We expect further yield rises and more curve steepening in 2021 (albeit not at the same pace as the first quarter). For investors, keeping a close watch on the duration of the portfolio and its benchmarks will likely be a key element in the more defensive stance we are advocating for fixed income.

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