Keep an Eye on Your Effective Duration
The bull market in equities will turn 11 years old in early March – and many investors believe it is getting long in the tooth, including me.
All business cycles eventually end, regardless of the efforts of the Federal Reserve or the president.
Generally, when a business cycle ends, a recession ensues – although in some cases the Fed has been able to engineer a “soft landing” and avoid recession.
But even when the Fed has been able to do this, the stock market enters a “correction” phase – at least a 10% decline.
When this happens, bonds have historically had their own way of reacting – and higher credit-quality bonds tend to perform better.
The reason for this is that corporate defaults are expected to increase during a recession, so investors buying lower-rated credits will demand higher coupons to compensate them for the perceived additional risk.
There is another factor at work, though, that may be a silver lining for lower credit-quality bonds…
Watch Effective Duration at the End of a Business Cycle
The effective durations of lower credit-quality bonds are shortening, while the effective durations of investment-grade bonds are lengthening.
If you’re not familiar with the term, duration measures how at risk a bond is to price shifts when interest rates are raised or cut. It’s measured in years and reflects how long it will take for the business’s loan to be repaid – but unlike maturity, it can speed up or slow down when the Fed changes rates.
And right now, low-quality bonds’ durations are shortening – which means investors are being rewarded even faster.
So why is that the case?
As bond yields have fallen over the past year, investment-grade companies have been trying to issue bonds with maturities as long as possible to lock in their borrowing costs at lower rates. That increases the effective durations of these bonds.
Lower credit-quality bonds, however, have a higher likelihood of being called. A company will lower credit costs by calling a higher-coupon bond and replacing it by reissuing a shorter, lower-coupon bond. This shortens the duration of those bonds.
Sam Goldfarb of The Wall Street Journal quantifies this trend…
Since the end of 2018, the average investment-grade bond duration has climbed 13% to 8.02 years, while the average speculative grade bond duration has dropped 24% to 3 years, according to Bloomberg Barclays data.
Goldfarb goes on to note that bonds in the Bloomberg Barclays High Yield index “yielded 5.17% on average, close to the all-time low of 4.83% set in June 2014. The average duration of the index is more than a year shorter than it was five and a half years ago.”
So there you have it – lower credit-quality bonds will do worse than higher credit-quality bonds when the business cycle ends, but there is a silver lining.
On average, lower credit-quality bonds as a group are becoming shorter, whereas durations of higher credit-quality bonds are becoming longer.
Investors who seek the most tried-and-true returns should still turn to highly rated blue chip bonds. However, “junk” bond aficionados can take comfort in the fact that businesses are paying generously for taking on their risk.
About Rob Morgan
Bond Expert Rob Morgan is a former financial advisor who led firms such as Sethi, Fulcrum Securities, Janney Montgomery Scott, Fulton Financial Advisors and Fifth Third Bank.
During his time at Fifth Third Bank, he managed a $160 million taxable bond fund.
He holds a CFA designation.
An MBA recipient from Vanderbilt University and submarine veteran of the U.S. Navy, Rob has made more than 700 media appearances on national networks, including CNBC.
He is also a Contributing Editor for Wealthy Retirement.
You can follow Rob on Twitter @RealRobMorgan.