There is More to Duration than One Number
What is the potential value of duration in an overall asset allocation? Explore Active Duration Management and the Western Asset Core Plus Bond Strategy.
With the interest rate environment evolving, investors are naturally thinking about their asset allocations, particularly their fixed income allocation. As part of this assessment, it’s imperative not to lose sight of the critical diversification role that duration can provide in an overall asset allocation, and the potential of active duration management.
The role of fixed income in an asset allocation
How strong is your core?
Duration is a key reason that fixed income can be an effective diversifier in an overall asset allocation. Longer-duration assets such as long-term U.S. Treasuries have at times exhibited negative beta and correlation to the S&P 500, which can serve as a ballast to equity and lower-quality credit assets, to help potentially offset losses when those risk assets come under pressure.
Duration has at times been a ballast to equity and lower-quality credit assets
Correlation and beta of select indexes: 8/1/1998 – 3/30/20181
Source: Morningstar, as of 3/30/2018. Past performance is no guarantee of future results. This chart is for illustrative purposes only and does not represent an actual investment. Unmanaged index returns do not reflect any fees, expenses or sales charges. Indexes are unmanaged and investors cannot invest directly in an index. All investments involve risk, including loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Equity securities are subject to price fluctuation and possible loss of principal. High-yield bonds are subject to greater price volatility, illiquidity and possibility of default. Municipal bond securities may subject investors to the federal Alternative Minimum Tax, and state and local taxes may apply. Capital gains, if any, are fully taxable. Active management and diversification do not ensure gains or protect against market declines. Leverage may result in greater volatility increasing and can increase risk of loss. U.S. Treasuries are direct debt obligations issued by the U.S. government and backed by its "full faith and credit." The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. See definitions of key terms at the bottom of the page.
The potential value of active duration management
Where duration comes from matters
Choosing where to get your duration on the yield curve can be critical, because rates do not move in unison. Performance will vary considerably for different maturity segments along the curve, because the front end of the yield curve is heavily influenced by Federal Reserve ("Fed") policy, while the back end of the yield curve is mainly driven by inflation and growth.
Active management can be used to identify where to position on the yield curve to obtain the desired duration. By looking at major points on the yield curve, the duration of a portfolio can be deconstructed to demonstrate the contribution from different points along the curve.
Key rate durations
Western Asset Core Plus Bond Strategy: 3/30/17 and 3/30/18
Source: Western Asset, as of 3/30/18. Data based on Western Asset Core Plus mutual fund. Data might not sum due to rounding. Duration may differ based on the type of accounts in which the strategy is offered. Click here for complete information on the Western Asset Core Plus Bond Fund. See definitions of key terms at the bottom of the page.
Tapering of the Federal Reserve Board's quantitative easing program and a general rise in interest rates may lead to increased portfolio volatility.
Duration posture is dynamic
Duration posture is the result of a dynamic investment process that reflects Western Asset’s macro views, its assessment of market valuation, and ongoing refinements in response to changing market conditions. For example, the duration of the Western Asset Core Plus Bond Strategy was shorter than that of the benchmark in 2011 and until mid-2013, at a time when the Fed was holding rates near zero and implementing a highly accommodative monetary policy. More recently, duration has been longer than that of the benchmark, guided by Western’s counter-consensus view that economic growth would remain moderate and inflation subdued—conditions that could favor more stable or even lower longer-term rates.
Duration exposure changes as market conditions shift
Western Assets Core Plus Bond Strategy versus Bloomberg Barclays U.S. Aggregate Bond Index
Sources: Western Asset and Bloomberg, as of 3/30/18. Duration may differ based on the type of accounts in which the strategy is offered. Data based on Western Asset Core Plus mutual fund. See definitions of key terms at the bottom of the page.
Philosophy in action
As evidenced in the chart to the right, a longer duration posture generated alpha for 2017 when short rates increased as the Fed continued to gradually raise rates, but long rates declined as inflation remained low. In other words, longer-term (higher-duration) securities significantly outperformed shorter-term (lower-duration) securities, which benefitted performance during 2017.
Longer-maturity bonds outperformed in 2017
2017 total returns from select index maturity ranges2
Source: Bloomberg, as of 12/31/17. Past performance is no guarantee of future results. This chart is for illustrative purposes only and does not represent an actual investment. Unmanaged index returns do not reflect any fees, expenses or sales charges. Indexes are unmanaged and investors cannot invest directly in an index. Performance for different time periods may vary. See definitions of key terms at the bottom of the page.
Bond markets are unpredictable.
Western's investment philosophy is not.
Whatever the market conditions, Western Asset’s investment philosophy is designed to identify undervalued securities from a range of complementary sectors, which may enhance current income and capital appreciation potential—the pillars of total return.
The Western Asset Core Plus Bond Strategy seeks to maximize total return via a well-diversified, long-term, value-based core fixed income strategy that includes limited opportunistic exposure to the “plus” sectors: high-yield, non-U.S. and emerging market debt.
What should I know before investing: Fixed income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. High-yield bonds are subject to greater price volatility, illiquidity and possibility of default. Derivatives, such as options and futures, can be illiquid, may disproportionately increase losses, and have a potentially large impact on Fund performance. International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Asset-backed, mortgage-backed or mortgage-related securities are subject to prepayment and extension risks. Potential active and frequent trading may result in higher transaction costs and increased investor liability. Active management does not ensure gains or protect against market declines.
1 The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S. High Yield Bonds are represented by the Bloomberg Barclays U.S. High-Yield 2% Issuer Capped Bond Index, which is a component of the U.S. Corporate High-Yield Bond Index, which covers the universe of fixed-rate, non-investment-grade corporate debt of issuers in non-emerging market countries. It is not market capitalization-weighted - each issuer is capped at 2% of the index. Leveraged Loans are represented by the Credit Suisse Leveraged Loan Index, which tracks the investable market of the U.S. dollar-denominated leveraged loan market. It consists of issues rated “5B” or lower, meaning that the highest-rated issues included in this index are Moody’s/S&P ratings of Baa1/BB+ or Ba1/BBB+. All loans are funded term loans with a tenor of at least one year and are made by issuers domiciled in developed countries. Corporate bonds are represented by the Bloomberg Barclays U.S. Corporate Bond Index, which measures the investment-grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers. The U.S. Corporate Index is a component of the U.S. Credit and U.S. Aggregate Indices. Long-term Municipal Bonds are represented by the Bloomberg Barclays Capital Municipal Bond Index, which is an unmanaged index of long-term, fixed-rate, investment-grade tax-exempt bonds. The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index of U.S. investment-grade fixed income securities. Long-term U.S. Treasuries are represented by the Bloomberg Barclays U.S. Treasury 20+ Year Index, which is the 20+ year component of the Bloomberg Barclays U.S. Treasury Index.
2 The Bloomberg Barclays U.S. Treasury Index is the U.S. Treasury component of the U.S. Government index. The index does not include T-bills, but it includes maturities of 1- 30 years. The average maturity was 7.66 years as of 3/30/18. The Bloomberg Barclays US Corporate Bond Index measures the investment-grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers. Index constituents must have at least one year to final maturity regardless of call features. Average maturity was 11.06 years as of 3/30/18. An alpha greater than zero suggests that the portfolio has outperformed during the period by means other than adding volatility.
Alpha is a measure of portfolio performance versus a benchmark, relative to the volatility of that benchmark. An alpha greater than zero suggests that the portfolio has outperformed during the period by means other than adding volatility.
Beta measures the sensitivity of an investment to the movement of its benchmark. A beta higher than 1.0 indicates the investment has been more volatile than the benchmark and a beta of less than 1.0 indicates that the investment has been less volatile than the benchmark.
Correlation is a statistical measure of the relationship between two sets of data. When asset prices move together, they are described as positively correlated; when they move opposite to each other, the correlation is described as negative or inverse. If price movements have no relationship to each other, they are described as uncorrelated.
Duration measures the sensitivity of price (the value of principal) of a fixed-income investment to a change in interest rates. The higher the duration number, the more sensitive a fixed income investment will be to interest rate changes.
Effective Duration provides a measure of sensitivity of a bond’s price to changes in interest rates and recognizes that changes in interest rates may also change expected cash flows generated by bonds with embedded options. Effective duration for an index is calculated as the weighted average of the effective durations of its individual bond constituents.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The yield curve shows the relationship between yields and maturity dates for a similar class of bonds.
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