WEBVTT - At the Money: Managing Bond Duration

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<v Speaker 1>Bloomberg Audio Studios, podcasts, radio news.

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<v Speaker 2>How should investors manage bond duration in an era of

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<v Speaker 2>rising and likely soon falling interest rates? The challenge. Long

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<v Speaker 2>duration bonds lose value when rates go up. Shorter duration

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<v Speaker 2>bonds can also lose value, but far less. What happens

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<v Speaker 2>when the reverse occurs when rates falls, well, the value

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<v Speaker 2>of long duration bonds go up, shorter duration go up

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<v Speaker 2>but less. As it turns out, there are many ways

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<v Speaker 2>investors can take advantage of changing interest rates. I'm Barry Ritolts,

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<v Speaker 2>and on today's edition of At the Money, we're going

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<v Speaker 2>to discuss how to manage your fixed income duration when

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<v Speaker 2>the Federal Reserve becomes active when it comes to interest rates.

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<v Speaker 2>To help us unpack all of this and what it

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<v Speaker 2>means for your portfolio, let's bring in Karen Vera. She

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<v Speaker 2>is head of I Shares US fixed Income strategy for

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<v Speaker 2>Investing Giant Blackrock. So Karen, let's just start with the basics.

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<v Speaker 2>What is duration, why does it matter? And why does

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<v Speaker 2>it seem so confusing to so many bond investors.

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<v Speaker 3>So duration is simply the interest rate risk of a bond,

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<v Speaker 3>or you can think about it, it's the amount that

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<v Speaker 3>the price is going to change in response to a

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<v Speaker 3>change in interest rates. So the nice thing is today

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<v Speaker 3>almost any bond or bond fund will typically have that

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<v Speaker 3>duration number published. So if the duration for examples five,

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<v Speaker 3>if interest rates go up by one percent, that bond

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<v Speaker 3>will drop in value by five percent. So it's a

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<v Speaker 3>pretty easy relationship to think about. I think where it

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<v Speaker 3>gets tricky is that that's just an average for the

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<v Speaker 3>bond or for the bond portfolio. But there's also durations

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<v Speaker 3>or the interest rate risk at different points on the

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<v Speaker 3>yield curve. So like two year, we call those key

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<v Speaker 3>rate durations, so you can think of how much am

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<v Speaker 3>I exposed to two year point, the five year point,

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<v Speaker 3>ten year point, twenty and thirty. And then we also

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<v Speaker 3>have something called credit spread duration. How much does the

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<v Speaker 3>bond's price change in response to changes in credit spread

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<v Speaker 3>or the additional yield over treasuries. So I think when

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<v Speaker 3>investors think through interest rate risk and how much risk

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<v Speaker 3>they want to take, duration is a helpful measure for

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<v Speaker 3>at least quantifying the loss that they could have from

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<v Speaker 3>changes in rates.

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<v Speaker 2>So let's look at some real life examples. The FED

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<v Speaker 2>began raising rates in March twenty twenty two. About eighteen

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<v Speaker 2>months later, they pretty much finished and we were over

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<v Speaker 2>five hundred points basis points higher then we began. How

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<v Speaker 2>did that impact bonds, both short and long duration.

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<v Speaker 3>We actually had an in twenty two, one of the

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<v Speaker 3>worst years in terms of bond performance in decades. The

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<v Speaker 3>AG or the aggregate index, which is the broad measure

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<v Speaker 3>of the tax wile bond market, was down about thirteen percent,

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<v Speaker 3>and that has an intermediate duration, our duration of between

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<v Speaker 3>five and six years. However, long bonds had double digit losses.

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<v Speaker 3>I think twenty plus year treasuries were down over twenty percent,

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<v Speaker 3>and I think that was really hurtful for a lot

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<v Speaker 3>of investors who had moved into bonds just coming off

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<v Speaker 3>of the zero interest rate policy that the FED adopted

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<v Speaker 3>after COVID.

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<v Speaker 2>And if memory serves me, I think twenty twenty two

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<v Speaker 2>was the first year since like nineteen eighty one where

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<v Speaker 2>both stocks and bonds were down double digit very unusual,

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<v Speaker 2>you know, twice a century sort of thing.

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<v Speaker 3>That's right, and it really comes back to, you know,

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<v Speaker 3>why we're interest rates going up whe it's stocks under

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<v Speaker 3>perform it and it goes back to the inflationary environment

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<v Speaker 3>post COVID inflation came back into the system and the

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<v Speaker 3>FED needed to do needed to tighten interest rates in

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<v Speaker 3>order to stop inflation and get the economy back on track.

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<v Speaker 3>And so you know, we had investors reacting to that,

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<v Speaker 3>and that's why we saw a year where both asset

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<v Speaker 3>classes were down.

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<v Speaker 2>So prior to the initiation of that rate hiking cycle

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<v Speaker 2>in twenty twenty two, it felt like, at least for

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<v Speaker 2>most of my adult life, going back to Paul Volker

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<v Speaker 2>as Chairman of the FED in the early eighties, interest

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<v Speaker 2>rates pretty much did nothing but go down. It felt like, hey,

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<v Speaker 2>for forty years we had nothing but on average lower rates.

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<v Speaker 2>Is that an exaggeration or is that pretty much what

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<v Speaker 2>took place?

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<v Speaker 3>No, no barrier spot on we did. We have seen

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<v Speaker 3>interest rates fall, and I think it's for a few

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<v Speaker 3>different reasons. I think the central bank got better at

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<v Speaker 3>managing inflation, so if inflation is lower than the absolute

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<v Speaker 3>level of rates are lower. We saw globalization where things

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<v Speaker 3>became cheaper, more efficient, And we also have an aging population.

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<v Speaker 3>In various studies we've seen that as economies age, interest

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<v Speaker 3>rates tend to be lower. Our biggest consumption behavior changes.

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<v Speaker 3>So we had all of those tailwinds kind of pulling

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<v Speaker 3>interest rates down over the years.

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<v Speaker 2>So that's forty years as far as you know. Is

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<v Speaker 2>that the longest bond bull market in history, or at

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<v Speaker 2>least in US history. I don't know what happened in

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<v Speaker 2>Japan a thousand years ago, but yeah, I.

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<v Speaker 3>Think in modern he we could say modern history. I

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<v Speaker 3>think that is a fair statement.

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<v Speaker 2>Right, and probably unlikely to ever be matched again in

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<v Speaker 2>our lifetime or perhaps our kids and grandkids. So let's

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<v Speaker 2>talk about what started a couple of years ago. The

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<v Speaker 2>yield curve inverted. How does that impact bond investors? If

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<v Speaker 2>you're getting paid the same for long duration as you

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<v Speaker 2>are for short duration, why would you want to hold

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<v Speaker 2>long duration paper?

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<v Speaker 3>Yeah, we've seen these inverted yield curves. They typically happen

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<v Speaker 3>before recessions, and they typically happen when the market expects

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<v Speaker 3>short term rates to come down following a period of

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<v Speaker 3>rates being risen higher. So we're at the point where

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<v Speaker 3>the yield curve is still inverted, and the response has

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<v Speaker 3>been pretty amazing by investors. They've all moved into ultrashort

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<v Speaker 3>duration bonds, money market funds, bank deposits, or at all

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<v Speaker 3>time highs In fact, even in August with a lot

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<v Speaker 3>of the market volatility, we just observed we saw very

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<v Speaker 3>strong flows coming into money market funds. So people are

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<v Speaker 3>literally sitting in cash. And then we have some data

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<v Speaker 3>on the average financial advisor's portfolio is about seven percent

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<v Speaker 3>in cash or ultra short term bonds, which is down

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<v Speaker 3>from over ten to fifteen percent, So now they're sitting

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<v Speaker 3>at seven. So we're still seeing a lot of even

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<v Speaker 3>professional investors are keeping their keeping things in cash in

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<v Speaker 3>response to this inverted yield curve.

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<v Speaker 2>So let's take a closer look at that. For a

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<v Speaker 2>long time, investors or cash holders were getting practically nothing

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<v Speaker 2>for a decade or so, but after the FED brought

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<v Speaker 2>rates up to five and a quarter, you could get

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<v Speaker 2>five percent and change in a fairly risk free money market.

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<v Speaker 2>What sort of competition does that create for longer duration

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<v Speaker 2>bonds and our money markets truly considered liquid cash, how

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<v Speaker 2>do you categorize them?

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<v Speaker 3>I'll take the money market fund question first, So we

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<v Speaker 3>do see money market funds are considered cash equivalents. You

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<v Speaker 3>can typically get your money back within a day, just

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<v Speaker 3>depending on the cutoff cycle you with the provider. So

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<v Speaker 3>we see a lot of people sitting in those cash

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<v Speaker 3>and ultra short term investments because they are liquid and

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<v Speaker 3>they are yielding a lot. However, we're seeing more people

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<v Speaker 3>wanting to add some duration. So if I can get

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<v Speaker 3>five percent today, that's great. But if the Fed starts

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<v Speaker 3>cutting in September December really moves that overnight rate back

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<v Speaker 3>down into that three percent range, which is what we

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<v Speaker 3>think it will do over the long term, those five

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<v Speaker 3>percent yields are going to disappear on you. So we

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<v Speaker 3>are seeing investors building bond ladders, adding intermediate duration because

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<v Speaker 3>when that yield curve does start to reshape more, normally,

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<v Speaker 3>where you get the most bang for your buck is

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<v Speaker 3>in the belly of the curve, that three to seven

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<v Speaker 3>year maturity. So not only can you lock in four

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<v Speaker 3>or five percent yields there, but then you can get

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<v Speaker 3>some price appreciation when interest rates begin to come down.

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<v Speaker 3>So that's really what we're seeing investors doing right now

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<v Speaker 3>is moving out the curve a bit in response to

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<v Speaker 3>the following rate environment that's coming.

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<v Speaker 2>So I'm glad you brought that up. We're recording this

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<v Speaker 2>right after the Labor Day holiday weekend in twenty twenty four.

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<v Speaker 2>Everybody has pretty much agreed Drome Palace come out and

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<v Speaker 2>said it, Hey, we're going to begin cutting rates. The

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<v Speaker 2>long wait is over. And you mentioned fifteen was it?

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<v Speaker 2>Fifteen trillion went down to seven trillion in money markets?

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<v Speaker 2>Is the assumption that a lot of this is flowing

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<v Speaker 2>into intermediate or longer dated bonds in anticipation of the

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<v Speaker 2>FED cutting wor is going on with all that cash

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<v Speaker 2>moving around.

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<v Speaker 3>We absolutely have seen a lot of people are still

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<v Speaker 3>staying put. So we don't see people moving until they

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<v Speaker 3>need to, until they actually see the rates drop on

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<v Speaker 3>some of their money fund money market funds. But we

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<v Speaker 3>are seeing some money coming into bondy tfs, both index

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<v Speaker 3>funds and active funds. We're seeing more people building out

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<v Speaker 3>bond ladders, so through term maturity ETFs such as our ivonds,

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<v Speaker 3>So we are seeing some of the money move. We're

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<v Speaker 3>actually looking up north to Canada. Canada's gone through a

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<v Speaker 3>few rate cuts now and we're seeing money in that

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<v Speaker 3>market move back into bonds quicker than in the US

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<v Speaker 3>on a percentage basis. So I think, well, we will

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<v Speaker 3>see a lot of money move this fall and into

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<v Speaker 3>twenty twenty five. I think when people actually notice that

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<v Speaker 3>the rates are coming down in some of these cash

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<v Speaker 3>like products.

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<v Speaker 2>So pardon my niavitae for asking such an obvious question.

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<v Speaker 2>If you wait for rates to fall to move into

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<v Speaker 2>longer duration bonds, haven't you missed it? I mean, don't

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<v Speaker 2>you want to extend your duration before the rate cuts begin.

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<v Speaker 2>In fact, we saw rates move down appreciably in August

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<v Speaker 2>following the most recent the CPI data point was very benign.

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<v Speaker 2>We've seen the restatement of labor data, which says, hey,

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<v Speaker 2>the labor market, while it's still healthy, it's much less

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<v Speaker 2>overheated than we previously thought. It seems like the bond

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<v Speaker 2>market is way ahead of both the stock market and

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<v Speaker 2>the Fed. How do you look at this?

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<v Speaker 3>Markets are great about getting ahead of the next cycle,

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<v Speaker 3>and we have seen that. We've seen interest rates coming

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<v Speaker 3>down across the curve even before the Fed has moved.

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<v Speaker 3>We think, though it's not too late, you're still going

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<v Speaker 3>to get There's some uncertainty about how quick the Fed

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<v Speaker 3>is going to cut, how quickly the yield curve is

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<v Speaker 3>going to reshape. So we're even using some of these

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<v Speaker 3>days when rates go back up a bit, those are

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<v Speaker 3>good entry points or better entry points to come back

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<v Speaker 3>to bonds, so we don't think it's too late, and

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<v Speaker 3>I think that the investors could rethink their strategy today

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<v Speaker 3>to kind of get ahead of the next wave of cuts.

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<v Speaker 2>So that's the perfect segue into investors who are interested

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<v Speaker 2>in fixing come and yield. What should these folks be

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<v Speaker 2>doing right here at the end of the summer in

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<v Speaker 2>twenty twenty four and heading into the fourth quarter.

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<v Speaker 3>I would say, think about your cash position. What are

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<v Speaker 3>you using that cash for. If it needs to be

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<v Speaker 3>liquid for expenses and emergency fund, keep it there. But

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<v Speaker 3>if it's part of your investment portfolio and you're just

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<v Speaker 3>seeking the highest amount of income, you should think through

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<v Speaker 3>what are the return to expectations over the next three, five,

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<v Speaker 3>ten years and really use the opportunity to get that

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<v Speaker 3>asset allocation back on track, that stock and bond mix

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<v Speaker 3>and move out to some of more intermediate duration, because

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<v Speaker 3>we think that's really where you're going to see the

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<v Speaker 3>biggest change in interest rates and you could get the

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<v Speaker 3>most both price appreciation as well as still some pretty

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<v Speaker 3>compelling income.

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<v Speaker 2>And our final question, how should investors be thinking about

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<v Speaker 2>the risk of longer duration fixed income paper?

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<v Speaker 3>So longer duration fixed in come paper does have almost

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<v Speaker 3>equity like volatility. It does have a double digit of volatility.

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<v Speaker 3>We do see it as a very efficient hedge against

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<v Speaker 3>equity markets. So if equity markets fall, we tend to

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<v Speaker 3>see that flight to quality and investors go towards those

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<v Speaker 3>long duration especially treasuries. We have a treasury ETFTLT it's

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<v Speaker 3>twenty plus years. It actually sell the highest amount of

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<v Speaker 3>inflows of any ETF vehicle in the month of August

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<v Speaker 3>because people were trying to hedge some of that equity

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<v Speaker 3>market volatility. So if you have a portfolio that's very

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<v Speaker 3>heavy in equities eighty ninety plus percent, you could add

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<v Speaker 3>a little bit of long duration bonds and that would

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<v Speaker 3>help smooth out the portfolio returns over time. So that's

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<v Speaker 3>really the role that we think of with longer duration bonds.

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<v Speaker 2>So to wrap up, investors who have been enjoying five

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<v Speaker 2>percent yields in money market and managing very short term

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<v Speaker 2>duration bond portfolios should recognize, hey, rake cuts are coming.

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<v Speaker 2>Jerome Palse said they were coming. This cycle is likely

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<v Speaker 2>to last more than just a cut or two. The

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<v Speaker 2>bond market is already starting to move yields down, and

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<v Speaker 2>if you wait too long, you're going to miss the

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<v Speaker 2>opportunity to lock in long duration, higher yielding bonds as

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<v Speaker 2>the cycle begins. I'm Barry Ridolts, and this is Bloomberg's

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<v Speaker 2>at the money.

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<v Speaker 1>Aside.

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<v Speaker 3>It is