January 1, 2025 • 13 mins
How should investors manage bond duration in an era of rising – and soon likely falling – interest rates?
The challenge is that the longer the duration your bonds are, the higher yield usually is, but the more vulnerable those bonds are to rising rates. When rates fall, long-duration bonds go up (shorter duration much less). There are many ways investors can take advantage of changing interest rates. For more on the subject, Barry Ritholtz speaks with Karen Veraa, Head of iShares US Fixed Income Strategy at BlackRock.
Each week, “At the Money” discusses an important topic in money management. From portfolio construction to taxes and cutting down on fees, join Barry Ritholtz to learn the best ways to put your money to work.
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Episode Transcript
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Speaker 1 (00:02):
Bloomberg Audio Studios, podcasts, radio news.
Speaker 2 (00:22):
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
(00:44):
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 changing interest rates. I'm Barry
Redtolts 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
(01:06):
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 I Shares 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.
Speaker 3 (01:28):
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 examples five,
(01:49):
if interest rates go up by one percent, that bond
will drop in value by five percent. 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
(02:11):
rate durations, so you can think of how much am
I exposed to two year point, the five year point,
ten year point, twenty and thirty. And then we also
have something called credit spread duration. How much 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
(02:33):
they want to take, duration is a helpful measure for
at least quantifying the loss that they could have from
changes in rates.
Speaker 2 (02:40):
So let's look at some real life examples. The FED
began raising rates in March twenty twenty two. About eighteen
months later, they pretty much finished and we were over
five hundred points basis points higher then we began. How
did that impact bonds, both short and long duration?
Speaker 3 (02:58):
We actually had an in two, 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 tax wile bond market, was down about thirteen percent,
and that has an intermediate duration, our duration of between
five and six years. However, long bonds had double digit losses.
I think twenty plus year treasuries were down over twenty percent,
(03:22):
and I think that was 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.
Speaker 2 (03:32):
And if memory serves me, I think twenty twenty two
was the first year since like nineteen eighty one where
both stocks and bonds were down double digit very unusual,
you know, twice a century sort of thing.
Speaker 3 (03:45):
That's right, and it really comes back to, you know,
why we're interest rates going up, why it's stocks under
perform it, And it goes back to the inflationary environment
post COVID inflation came back into the system and the
Fed needed to do needed to tighten interest rates in
order to stop inflation and get the economy back on track.
And so you know, we had investors reacting to that,
(04:07):
and that's why we saw a year where both asset
classes were down.
Speaker 2 (04:10):
So prior to the initiation of that rate hiking cycle
in twenty twenty two, it felt like, at least for
most of my adult life, going back to Paul Volker
as Chairman of the FED in the early eighties, interest
rates pretty much did nothing but go down. It felt like, hey,
for forty years we had nothing but on average lower rates.
(04:31):
Is that an exaggeration or is that pretty much what
took place?
Speaker 3 (04:35):
No barrier spot on we did. 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. In
various studies we've seen that as economies age, interest rates
(04:59):
tend to be lower, biggest consumption behavior changes. So we
had all of those tailwinds kind of pulling interest rates
down over the years.
Speaker 2 (05:06):
So about forty 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.
Speaker 3 (05:17):
Yeah, I think in modern we could say modern history.
I think that is a fair statement, right.
Speaker 2 (05:21):
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
getting paid the same for long duration as you are
for short duration, why would you want to hold long
(05:43):
duration paper?
Speaker 3 (05:44):
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. So 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 ultrashort
(06:04):
duration bonds, money market funds, bank deposits, or 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 funds, so people are
literally sitting in cash. And then we have some data
on the average financial advisor's portfolio is about seven percent
(06:25):
in cash or ultra short term bonds, which is down
from over ten to fifteen percent, So now they're sitting
at seven. So we're still seeing a lot of even
professional investors are keeping their keeping things in cash in
response to this inverted yield curve.
Speaker 2 (06:39):
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
five percent and change in a fairly risk free money market.
(07:00):
What sort of competition does that create for longer duration
bonds and our money markets truly considered liquid cash, how
do you categorize them?
Speaker 3 (07:12):
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 your 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
(07:34):
people wanting to add some duration. So if I can
get five percent today, that's great. But if the Fed
starts cutting in September December really moves that overnight rate
back down into that three percent range, which is what
we think it will do over the long term, those
five percent yields are going to disappear on you. So
we are seeing investors building bond ladders, adding intermediate duration
(07:54):
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 three to seven
year maturity. So not only can you lock in four
or five percent yields there, but then you can get
some price appreciation when interest rates begin to come down.
So that's really what we're seeing investors doing right now
is moving out the curve a bit in response to
(08:15):
the following rate environment that's coming.
Speaker 2 (08:17):
So I'm glad you brought that up. We're recording this
right after the Labor Day holiday weekend in twenty twenty four.
Everybody has pretty much agreed Drome Palace come out and
said it, Hey, we're going to begin cutting rates. The
long wait is over. And you mentioned fifteen was it?
Fifteen trillion went down to seven trillion in money markets?
(08:39):
Is the assumption that a lot of this is flowing
into intermediate or longer dated bonds in anticipation of the
FED cutting word is going on. With all that cash
moving around.
Speaker 3 (08:51):
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 BONDI tfs, both index
funds and active funds. We're seeing more people building out
bond ladders so through term mature to ETFs such as
(09:13):
our ivonds, So we are seeing some of the money move.
We're actually looking up north to Canada. Canada has 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, well,
we will see a lot of money move this fall
and into twenty twenty five. I think when people actually
(09:33):
notice that the rates are coming down in some of
these cash like products.
Speaker 2 (09:36):
So pardon my niavite 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.
(10:00):
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?
Speaker 3 (10:19):
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
(10:42):
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.
Speaker 2 (10:53):
So that's the perfect segue into investors who are interested
in fixing come and yield. What should these folks be
doing right here at the end of the summer in
twenty twenty four and heading into the fourth quarter.
Speaker 3 (11:08):
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 to 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
(11:32):
and move out to some of more intermediate duration, 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.
Speaker 2 (11:43):
And our final question, how should investors be thinking about
the risk of longer duration fixed income paper?
Speaker 3 (11:51):
So longer duration fixed income paper does have almost equity
like volatility. It does have of double digit of 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 towards those
long duration especially treasuries.
Speaker 1 (12:10):
We have a.
Speaker 3 (12:10):
Treasury ETF TLT it's twenty 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 eighty ninety plus percent,
you could add a little bit of long duration bonds
and that would help smooth out the portfolio returns over time.
(12:33):
So that's really the role that we think of with
longer duration bonds.
Speaker 2 (12:36):
So to wrap up, investors who have been enjoying five
percent yields in money market and managing very short term
duration bond portfolios should recognize, hey, rakecuts are coming. Jerome
Palse said they were coming. This cycle is likely to
last more than just a cut or two. The bond
(12:57):
market is already starting to move yields down, and if
you wait too long, you're going to miss the opportunity
to lock in long duration, higher yielding bonds as the
cycle begins. I'm Barry Redolts and this is Bloomberg's at
the money is it is
Bloomberg Audio Studios, podcasts, radio news.
Speaker 2 (00:22):
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
(00:44):
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 changing interest rates. I'm Barry
Redtolts 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
(01:06):
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 I Shares 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.
Speaker 3 (01:28):
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 examples five,
(01:49):
if interest rates go up by one percent, that bond
will drop in value by five percent. 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
(02:11):
rate durations, so you can think of how much am
I exposed to two year point, the five year point,
ten year point, twenty and thirty. And then we also
have something called credit spread duration. How much 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
(02:33):
they want to take, duration is a helpful measure for
at least quantifying the loss that they could have from
changes in rates.
Speaker 2 (02:40):
So let's look at some real life examples. The FED
began raising rates in March twenty twenty two. About eighteen
months later, they pretty much finished and we were over
five hundred points basis points higher then we began. How
did that impact bonds, both short and long duration?
Speaker 3 (02:58):
We actually had an in two, 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 tax wile bond market, was down about thirteen percent,
and that has an intermediate duration, our duration of between
five and six years. However, long bonds had double digit losses.
I think twenty plus year treasuries were down over twenty percent,
(03:22):
and I think that was 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.
Speaker 2 (03:32):
And if memory serves me, I think twenty twenty two
was the first year since like nineteen eighty one where
both stocks and bonds were down double digit very unusual,
you know, twice a century sort of thing.
Speaker 3 (03:45):
That's right, and it really comes back to, you know,
why we're interest rates going up, why it's stocks under
perform it, And it goes back to the inflationary environment
post COVID inflation came back into the system and the
Fed needed to do needed to tighten interest rates in
order to stop inflation and get the economy back on track.
And so you know, we had investors reacting to that,
(04:07):
and that's why we saw a year where both asset
classes were down.
Speaker 2 (04:10):
So prior to the initiation of that rate hiking cycle
in twenty twenty two, it felt like, at least for
most of my adult life, going back to Paul Volker
as Chairman of the FED in the early eighties, interest
rates pretty much did nothing but go down. It felt like, hey,
for forty years we had nothing but on average lower rates.
(04:31):
Is that an exaggeration or is that pretty much what
took place?
Speaker 3 (04:35):
No barrier spot on we did. 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. In
various studies we've seen that as economies age, interest rates
(04:59):
tend to be lower, biggest consumption behavior changes. So we
had all of those tailwinds kind of pulling interest rates
down over the years.
Speaker 2 (05:06):
So about forty 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.
Speaker 3 (05:17):
Yeah, I think in modern we could say modern history.
I think that is a fair statement, right.
Speaker 2 (05:21):
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
getting paid the same for long duration as you are
for short duration, why would you want to hold long
(05:43):
duration paper?
Speaker 3 (05:44):
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. So 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 ultrashort
(06:04):
duration bonds, money market funds, bank deposits, or 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 funds, so people are
literally sitting in cash. And then we have some data
on the average financial advisor's portfolio is about seven percent
(06:25):
in cash or ultra short term bonds, which is down
from over ten to fifteen percent, So now they're sitting
at seven. So we're still seeing a lot of even
professional investors are keeping their keeping things in cash in
response to this inverted yield curve.
Speaker 2 (06:39):
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
five percent and change in a fairly risk free money market.
(07:00):
What sort of competition does that create for longer duration
bonds and our money markets truly considered liquid cash, how
do you categorize them?
Speaker 3 (07:12):
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 your 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
(07:34):
people wanting to add some duration. So if I can
get five percent today, that's great. But if the Fed
starts cutting in September December really moves that overnight rate
back down into that three percent range, which is what
we think it will do over the long term, those
five percent yields are going to disappear on you. So
we are seeing investors building bond ladders, adding intermediate duration
(07:54):
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 three to seven
year maturity. So not only can you lock in four
or five percent yields there, but then you can get
some price appreciation when interest rates begin to come down.
So that's really what we're seeing investors doing right now
is moving out the curve a bit in response to
(08:15):
the following rate environment that's coming.
Speaker 2 (08:17):
So I'm glad you brought that up. We're recording this
right after the Labor Day holiday weekend in twenty twenty four.
Everybody has pretty much agreed Drome Palace come out and
said it, Hey, we're going to begin cutting rates. The
long wait is over. And you mentioned fifteen was it?
Fifteen trillion went down to seven trillion in money markets?
(08:39):
Is the assumption that a lot of this is flowing
into intermediate or longer dated bonds in anticipation of the
FED cutting word is going on. With all that cash
moving around.
Speaker 3 (08:51):
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 BONDI tfs, both index
funds and active funds. We're seeing more people building out
bond ladders so through term mature to ETFs such as
(09:13):
our ivonds, So we are seeing some of the money move.
We're actually looking up north to Canada. Canada has 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, well,
we will see a lot of money move this fall
and into twenty twenty five. I think when people actually
(09:33):
notice that the rates are coming down in some of
these cash like products.
Speaker 2 (09:36):
So pardon my niavite 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.
(10:00):
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?
Speaker 3 (10:19):
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
(10:42):
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.
Speaker 2 (10:53):
So that's the perfect segue into investors who are interested
in fixing come and yield. What should these folks be
doing right here at the end of the summer in
twenty twenty four and heading into the fourth quarter.
Speaker 3 (11:08):
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 to 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
(11:32):
and move out to some of more intermediate duration, 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.
Speaker 2 (11:43):
And our final question, how should investors be thinking about
the risk of longer duration fixed income paper?
Speaker 3 (11:51):
So longer duration fixed income paper does have almost equity
like volatility. It does have of double digit of 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 towards those
long duration especially treasuries.
Speaker 1 (12:10):
We have a.
Speaker 3 (12:10):
Treasury ETF TLT it's twenty 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 eighty ninety plus percent,
you could add a little bit of long duration bonds
and that would help smooth out the portfolio returns over time.
(12:33):
So that's really the role that we think of with
longer duration bonds.
Speaker 2 (12:36):
So to wrap up, investors who have been enjoying five
percent yields in money market and managing very short term
duration bond portfolios should recognize, hey, rakecuts are coming. Jerome
Palse said they were coming. This cycle is likely to
last more than just a cut or two. The bond
(12:57):
market is already starting to move yields down, and if
you wait too long, you're going to miss the opportunity
to lock in long duration, higher yielding bonds as the
cycle begins. I'm Barry Redolts and this is Bloomberg's at
the money is it is
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