Following the pandemic, bonds have returned to offering interesting returns after 15 years of extremely low returns.
The relevance of duration in a changing rate environment
Many investors sought refuge in short-term investments during rising interest rates. The shorter the maturity of the bond, the less negative the effect of interest rate increases on the price of the bond. That is why we launched our Savings Portfolios at that time, which were a great success with our clients. These portfolios, built with money market funds, were a very good investment vehicle as central banks were raising interest rates.
Now, many investors believe that interest rates will continue to fall and that it is time to extend maturities, even though long-term yields, especially in Europe, do not appear to be particularly attractive.
Although we still believe that Savings Portfolios still make perfect sense for having an emergency fund, at inbestMe we have created a range of bond portfolios that clients can use to move from money market funds to bonds with a longer maturity. Specifically, based on the client’s risk profile and preferences, we have built three types of bond portfolios: a conservative one, with very low duration and volatility, a more aggressive one, with greater duration and volatility, and some Target Portfolios with maturities in 2025, 2026, 2027 and 2028.
Choosing the maturities of bonds in which to invest involves a compromise between interest rate risk and reinvestment risk.
In practice, those who buy bonds with longer durations are more exposed to market price fluctuations due to greater interest rate sensitivity. However, they are assured of a certain return over a long period. If, for example, a person were to buy a 10-year bond with a 3% annual yield, they would be assured (provided the bond issuer does not default on its obligations) of receiving a 3% return over the next 10 years, but during these 10 years they might face significant ups and downs in the bond’s price.
Those who buy short durations are less exposed to price fluctuations, but face a higher reinvestment risk: once the short-term bond matures, the investor may find lower yield levels in which to reinvest his capital. He could buy a one-year bond with a 3% yield, but by the time the bond matures, the level of the yield could have decreased or increased.
Short-term vs. long-term: the investor’s dilemma
So what is better, staying in money market funds or moving to longer maturities?
It all depends on personal expectations regarding interest rates and, especially, on the personal objectives of the investor.
If a person needs the money soon, or believes bond yields will be higher in the future, he or she is better off leaving his or her money invested in a liquid money market, whose value does not change significantly over time.
If, on the other hand, that same person does not need the money soon, or believes that bond yields are going to decrease, it is better to increase the duration.
he chart below shows how much a bond’s yield would have to increase in the market, assuming a 3% coupon and a specific maturity (indicated on the X-axis), to incur a capital loss after one year. For example, for a 10-year bond, a yield increase of more than 0.39% would already lead to capital losses after one year, while for a 2-year bond, a much larger increase of 3.19% would be necessary.
Alternatively, it can be interpreted as the expected increase in yield needed to justify waiting a year before investing in that maturity, rather than buying the bond today. This decision would only make sense if a more significant increase in yield is anticipated.
The chart, for its part, provides a visual representation of the magnitude of the increase in the expected yield for each maturity, from which a capital loss would be incurred after one year.
Of course, there are many other considerations that come into play when making bond portfolio purchasing decisions. These include:
- Investor time horizon: the shorter the investment horizon, the shorter the recommended duration.
- The desired stock risk decorrelation function: if the relationship between bonds and stocks turns negative again, a longer duration could imply a greater decorrelation of stock risk.
- Volatility tolerance: to invest in high-duration instruments, the investor must have a higher risk tolerance.
We believe it is interesting to know as much as possible about these technicalities. But in reality our clients do not have to worry. All these considerations are taken into account in the registration process to recommend the best portfolio based on all these factors.
At inbestMe we offer a full range of bond portfolio alternatives, which adapt to the objectives and different preferences of investors in terms of duration and risk:
As shown in the table above (see APY column), in 2024 annualized returns have already reflected the new reality of the bond market, being very good and ranging between 4.5% and 7.3% in euros, and between 5.5% and 7.6% in dollars with very low volatilities.
Adjusting duration in diversified portfolios
Duration management in diversified portfolios (index funds, ETFs and pension plans) was a challenge that the investment committee addressed during 2021, in anticipation of the rise in interest rates by central banks. At that time, duration was significantly reduced, which helped partially mitigate the falls in the most conservative profiles (profiles 1 and 2). As an additional illustration to what was noted in the previous paragraphs, if the original duration had been maintained, the losses would have been even greater.
As shown in the attached chart, despite the difficulties faced even after adopting these measures, these portfolios have already recovered and even surpassed the level prior to the rate hikes (early 2022). In contrast, other portfolios offered by services similar to inbestMe are still well below this level, with losses of more than 15% still pending recovery.
Since the end of 2023 and throughout 2024, the duration has increased moderately, although it still remains below previous levels, given the lack of complete normalization in the yield curve.
This and other factors are constantly monitored by the Investment Committee as part of our automated managed portfolio service, ensuring that they maintain optimal allocation. In addition to this ongoing monitoring, a further in-depth review of all portfolios is being carried out now, as we head into the year.
