Monday, July 18, 2016

The impact of duration on bond volatility

The march lower of interest rates lengthens the duration of bonds. For a given move in rates, there will be a greater change in total return and there will be less cushion coming from yield. While all investors implicitly know this, the magnitude of the duration change has not ben trivial in the current environment and may surprise many. This is especially the case for longer maturity bonds.

The decline in rates from before the Financial Crisis has led to an increase in the duration of the long bond by 50%. Whether rates move further toward zero or a back-up to higher levels, the price impact of that rate change will be greater than in the past. 

One of the reasons for the strong negative correlation between stocks and bonds is the fact that the bond price change for a given change in rates is greater. The cushion of higher yields will cause the correlation to stay closer to zero. If there is no cushion, the correlation will become more variable based on the relationship between stocks and interest rates.

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