What duration for a bond portfolio?

A few thoughts as the FED prepares to launch its rate-cutting cycle.

Duration back in the spotlight

Since the financial crisis of 2008 and the economic repression introduced by central banks through their quantitative easing programmes, long-dated bonds had lost some of their appeal. The last remaining attraction disappeared in the aftermath of the Covid crisis, when the same central banks injected massive amounts of liquidity into the market, sending bond yields falling. In fact, it hardly seemed relevant to invest in long-term bonds with yields close to zero. Since 2021, however, we have seen a paradigm shift, with the return of inflation forcing the Fed, in particular, to raise its key rates to an extent never seen before. Today, the US central bank is about to embark on a cycle of rate cuts (which have remained unchanged at around 5.25% since July 2023), against the backdrop of an economic slowdown marked by a weaker job market. These fears about growth are finally driving down the correlation between equities and bonds and, in this context, duration is once again becoming an attractive option for building an investment portfolio.

Favour short to intermediate durations

For the sake of simplicity, let’s focus on developed markets and run the US 10-year yield as a proxy for longer-dated bonds. To mechanically determine a theoretical target value for this yield, we can start from the FED’s neutral key rate, given by its last dot plot in June (2.8%) and add a time premium to it, which will vary according to the reference period and which is justified in particular by the uncertainties linked to future inflation. Historically, this premium between the Fed’s key rate and US 10-year yields has been between 1% and 2% or between 0.5% and 1.5% since the 2008 financial crisis. Taking averages, we can therefore conclude that the US 10-year yield should be 4.3%, if we assume that we are moving away from the paradigm that has prevailed since the financial crisis, or 3.8%, if we assume that we are still in a similar context. At the time of writing, the US 10-year yield is 3.66%. We can therefore conclude that, in theory and in the absence of a hard landing marked by a recession in the United States, long-term bond prices (which move inversely to yields) are slightly overvalued by the market. On top of this, the fundamentals are not very reassuring about the sustainability of the US budget, with deficits comparable to those in the days following the Second World War. Investing in this type of investment therefore does not seem appropriate.

A more reasonable option, and one that nevertheless adds a little duration to a portfolio, would be to opt for a short to intermediate duration. Here, we can run the 2-year rate, for example. Replicating the same analysis as for long rates, we obtain a historical time premium of 0.5% to 1% and almost zero for the period following the financial crisis, which gives us theoretical target values of between 2.8% and 3.55% depending on the macroeconomic context, whereas the current yield is 3.56%. We can see here that the market value and the theoretical price are more in line and that there is even an opportunity if we stay in a market similar to the post-financial crisis period.

The investor’s context

In reality, there is no exact universal solution when it comes to choosing duration within a portfolio, as each portfolio has its own characteristics to meet the needs of the client. An approach that favours the long end of the curve may still be justified, for example to hedge the risk associated with a portfolio that has a high exposure to cyclical equities. First and foremost, you need to identify the risk and return constraints specific to each portfolio before making your choice. It is also important to take a macroeconomic view when deciding on the time premium to be added to the target return for each maturity. These points are not intended to be exhaustive, but they should help bond investors in their allocation decisions at a time when duration is finally regaining popularity.

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Chart of the month: The incredible bull market in bonds

Chart of the month

The incredible bull market in bonds

“You seem to have this nasty habit of surviving, Mister Bond”

When Kamal Khan tells James Bond that he has a nasty habit of surviving in “Octopussy” in 1983, he does not refer to the bond market obviously….. But funny enough the year the movie was released more or less corresponds to the start of one of the longest bull markets in history, precisely on bonds.

At the end of the year 2012 one could have thought that good days were over and that being a bond investor, in particular on 10 year Government benchmarks, would become quite a challenging job. At that time markets were increasingly expecting the end of Quantitative Easing by the Federal Reserve, and a progressive “normalization” of the structure of the US yield curve. The reasons were pretty straightforward: self-sustained economic growth, better global growth prospects, improving housing and job markets, strong banking sector, and the list goes on.

The natural path of US government bonds yields was clearly on the upside, and a steepening of the yield curve was widely expected… and happened as US 10 year yields more than doubled from a low of 1.38% in July 2012 to a high of 3.05% in January 2014, a period during which the Fed talked a lot but barely acted (no changes were made on the interest rates side, but QE program was gradually tuned down).

Since then a new sequence of strong performance occurred on the bond side, with US 10 year yields falling back to 2% (as of January 2015) with a short incursion into the 1.60-1.70% zone at the beginning of 2015. What has happened to push yields to such low levels again? Here also the reasons seem quite obvious with hindsight: the initial big down move was triggered by the first spectacular fall in oil prices which started in July 2014 and ended at the beginning of 2015 (from $108 to $42 per barrel), perfectly matching the US 10 year yield move from 3.05% to 1.64%. The second round of falling yields started in June 2015 and is still in place today….there again perfectly correlated to the second round of falling oil prices.

On top of this spectacular fall in oil prices one can add the considerable weakness in almost all commodity prices, so there seems to be a logical reaction from fixed income markets which are anticipating non-existent inflationary – or even rising deflationary – pressures.

Another striking correlation comes with the Chinese Renminbi which peaked in January 2014 (like oil and US 10 year yields) at 6.04 per USD and has fallen to 6.58 per dollar since then. This is a very important event because there are now serious fears that China is on its way to let its currency depreciate further, which would certainly generate a wave of deflationary pressures around the globe.

What can be expected from now on with bonds? With such low levels the risk/reward proposal still appears unattractive and it seems to make more sense to invest on relatively short maturities (maximum 5 years) in order to roll down the curve while it’s still steep. But what if the doomsayers got it right? The Japanese recent history shows that first it is complicated to fight against deflation once it’s in place, and second that it is a highly risky business to bet against a bond market. Those having made money by shorting JGBs are the very lucky few, everybody else having lost money and patience.

And to remind us that this mid-80s – 2015 period has been exceptional, one quick look at the 30 year benchmark issued by the US Treasury in February 1986 and which matures next month is highly illustrative: with a 9.25% coupon, issued at par and reimbursed at par, an investor would have made a 9.25% return annualized, the maths are simple. During the same timeframe, the SP500 with dividends has compounded at 10.3%, a mere 1% better, but with far much more sleepless nights.

So yes, Mr Bond Market, you have a pretty nasty habit to survive!