People are more focused than ever on the risk in their portfolio - and with interest rates so low, there is particular attention being paid to the risk in one’s bond portfolio. But how much interest rate risk is in your portfolio?
One way to evaluate this risk is by quantifying the “duration” of a portfolio. In its simplest form, you could think of duration as the dollar-weighted-average timing of when you will receive your money back (both principal AND interest for a bond - so maturity is not the entire story). A slightly more sophisticated form, “effective duration” takes into account a bond/portfolio’s anticipated value change in response to a change in interest rates.
While this value can be difficult to quantify, especially when bonds are callable by the issuer or involve prepayment risk (as with mortgage bonds), there is good news for those wishing to quantify the duration in a portfolio of bond mutual funds. With rare exceptions, a bond fund will either make this number available on its website, or at least file enough information with the government that a third-party research site like Morningstar will quantify the effective duration - available on its site for free ( www.Morningstar.com).
So what’s your own exposure? A simple weighted average can tell you a lot of what you need to know. Let’s say your bond portfolio consists of $600K - split evenly between three of the most popular bond funds: $200K in each of Pimco Total Return (ticker PTTRX, duration 4.7), Vanguard Total Bond Market Index (ticker VBMFX, duration 5.3) and Rochester Municipals (ticker RMUNX, duration 14.5). Given the equal weightings in the portfolio described, we could simply add the three durations and divide by three, for an estimated average effective duration of 8.2. (If your portfolio, like most people’s, is not equally weighted, email me at firstname.lastname@example.org for a spreadsheet that will allow you to calculate an average weighted by holding size in dollars).
So what is this hypothetical duration of 8.2 telling us? Remember that yields on a one-year bond are not the same as those of a 10-year bond. And, of course, a seven-year municipal bond will likely have a very different yield than a seven-year high-yield corporate bond. Acknowledging those key qualifiers, let’s suggest a way one could apply the portfolio duration would be to say “ If yields for all types of bonds of all maturities go up by 1%, this portfolio could lose approximately 8% of value”. That could be a tough pill to swallow when you consider the 10-year treasury bond (currently 2.1%) was 5.0% just seven years ago.
Take a look at your portfolio - are the individual bonds maturing in 10 or more years? If bond funds, are the durations comfortably short? If you have a number of individual bonds in your portfolio, does your custodian provide you a duration statistic you can monitor? Sure, bonds have likely served you well over the past 20+ years - but if you ignore what’s under the hood now, you do so at your peril.