Ken Solow   |   February 9, 2012

The duration of a bond portfolio tells you how much the price of your bonds will change for each percentage change in interest rates. A high duration means more sensitivity or price volatility as interest rates change. Duration tells you virtually everything you want to know about the price sensitivity of U.S. government bonds, which are presumed to be risk-free from the standpoint of default risk. Prices of government bonds move with a mathematical certainty depending on the coupon and the maturity of the bonds, both of which go into the duration calculation. Investors increase the duration of their portfolio by increasing the maturity of the bonds they own, and shorten the duration by shortening bond maturities. As you move up the risk-of-default scale from government bonds, you can invest in what is known as “spread products,” or bonds that are priced based on the difference, or spread, in their yield to U.S. Treasury securities. Spread products include mortgage bonds, high quality corporate bonds, junk bonds, and emerging market bonds, all of which typically offer investors higher yields in exchange for a higher risk of default. The price of spread products is not only impacted by their duration, but is also greatly affected by investor’s perceptions of the default risk of the underlying bonds. These bonds are priced on their creditworthiness, and are often simply referred to as credit.

Bond prices move inversely to changes in interest rates. When rates go up bond prices fall, and when interest rates fall, bond prices rise. If you want to defend against a slow economy and falling interest rates, then the easiest way to do it is to add duration to your bond portfolio by buying high quality (no default risk) government bonds. On the other hand, if the economy is growing and you want to defend against higher interest rates, you want to own spread products, or credit. These bonds should hold their value better than government bonds in a rising interest rate environment because:

1. Higher rates might be caused by a strong economy, which reduces the risk of default and puts a bid under bond prices.
2. The higher coupon offered by the bonds tends to cushion price changes caused by higher interest rates.

So, to review, if you want to defend against recession, increase your portfolio duration. And if you want to defend against higher interest rates caused by economic growth, own credit.

This week Pinnacle’s analysts considered the relatively low duration and high cash concentrations in our fixed income allocations. Last year we were concerned with defending the portfolio from volatility in our equity positions, but found it difficult to buy duration, or government bonds, due to their low yields and high prices. We ended up with relatively high allocations to cash. Of course government bonds promptly became the best performing asset class of the year as yields fell even further due to a slowing global economy, mass risk aversion, and buying by the Federal Reserve, China, and Japan.

As we consider moving the portfolio’s risk positions towards neutral this year, we’re facing the same conundrum. Should we buy credit to defend against higher interest rates and an equity rally, even though stocks have had a nice run and are arguably trading at the top of their range? Or should we buy government bonds to defend against an equity correction, even though yields are even lower than they were at this time last year and the bonds are even more expensive? The answer is that we will buy both, in small amounts, to push the overall interest rate sensitivity of the portfolio closer to our benchmark duration, and to increase the yield coming from our fixed income portfolios. Pinnacle clients should look for those trades to hit their accounts next week.