Duration: To Hedge or Not to Hedge?

We find that for many investors concerned about rising interest rates, low duration strategies tend to offer a higher yield along with lower volatility than their duration-hedged counterparts.

Many fixed income investors are watching global economic developments (government bond yields at dramatic lows, the Federal Reserve poised to start hiking rates later this year) and evaluating ways to manage the risk that a rising rate environment could erode their bond allocations.

We would argue that this fear of duration is often misplaced, especially over the longer term, as investors tend to get rewarded for taking duration risk, even if rates go up (please see the February 2015 Viewpoint,The Case for Duration in the Long Run”). But for clients who do want to take duration risk, we broadly speaking see three strategies, each with a different risk and return profile:

  • Aim to structurally reduce interest rate risk by moving to a low duration bond strategy, which is anchored to a lower duration benchmark, swapping longer-dated for shorter-dated bonds (for instance, by moving from a benchmark that spans the entirety of bond markets to a version that includes bonds with maturities between one and five years; for this paper, we define a low duration strategy as having a duration band of one to five years).
  • Aim to structurally limit interest rate risk via a duration-hedged approach, which keeps the bond portfolio itself intact but hedges interest rate risk with derivatives.
  • Switch to a more dynamic, unconstrained bond strategy with an absolute return target and the flexibility to navigate changing investment landscapes with skill.

For investors who favor a more traditional approach in their bond portfolios – i.e., investors more likely to focus on managing duration risk via one of the first two strategies rather than take the unconstrained approach – comparing the potential benefits and risks of low duration versus duration-hedged strategies is a primary focus.

We find that for many investors concerned about rising interest rates, low duration strategies are a more attractive approach: They can be less complex, because they are less likely to require derivatives to hedge out the duration, and they tend to offer a higher yield along with lower volatility than their duration-hedged counterparts. This may seem counterintuitive, and it is the result of duration being only one of the risks in bond portfolios. Other risks, such as credit risk, remain, and historically when credit spreads widen, interest rates typically fall. This tends to mitigate the negative impact of spread widening on portfolio return, therefore lowering volatility. Also, because duration tends to be an important component of the return profile in a bond portfolio, adjusting exposure rather than hedging it away may make sense for many investors. Of note, these trends are generally consistent across bond strategies, including investment grade credit, high yield, emerging market hard currency and inflation-linked bonds.

Hedging duration risk can reduce yield and expected return

Bond portfolio duration can be hedged by paying a fixed rate on interest rate swaps or by taking short positions in bond futures. With yield curves upward-sloping in all major currencies (see Figure 1), duration hedging pays away a higher, longer-dated yield and receives a lower, shorter-dated yield. This reduces yield. For example, the yield on the Barclays Global Aggregate Credit index was 2.4% as of 27 February 2015, but yield on the duration-hedged version was 1.4%. We see a similar disparity in the Bank of America Merrill Lynch (BAML) U.S. High Yield BB-B Constrained index, which has a yield of 5.7%, versus 4.6% for the duration-hedged equivalent.

Yield curves are upward sloping for various reasons. Many market participants expect interest rates to rise at some point in the future, and this gets priced into the yield curve. In addition, investors generally demand higher yields for the risks involved in buying longer-dated bonds. When they hedge duration, investors forgo this term premium, and therefore may reduce the longer-term expected return on the duration-hedged portfolio.

This is important, because it means a duration-hedged strategy can outperform a non-hedged strategy only if interest rates rise more than what is embedded in the yield curve. Forgoing the term premium also means that duration hedging is likely to underperform a low (or standard) duration strategy over the long term. That said, for investors who understand the risk/reward profile of duration hedging, it may be viable as a shorter-term tactical strategy, requiring investors to time the switch into and out of duration hedging.

Performance in a rising rate environment: the mirror exercise

To illustrate the importance of this potential yield/carry return difference between a duration-hedged bond portfolio and its corresponding unhedged portfolio, we can simulate the performance of the Barclays U.S. Aggregate Credit Index (duration-hedged and unhedged) under a rising rates scenario. While we could use any hypothetical rising rate scenario, we opted for an illustration that may look familiar by assuming U.S. credit yields and spreads over Treasuries followed a path that was the mirror image of their path of the past 15 years. In other words, we evaluate how these indexes would perform if the forward path for rates and spreads retraced what we experienced historically, in reverse. For example, beginning at the 2.9% yield and 1.2% spread as of year-end 2014, in 2015 we would see a gradual rise in rates to close the year at 3.2% yield and 1.1% (where we were at year-end 2013), then a “reverse taper tantrum” in 2016 (reflecting May 2013), a major spike in spreads in 2020 (reflecting the Financial Crisis of 2008–2009), etc. until 2029 when yields stand at 1999 levels of 7.5% and spreads at 1.1%. (For another example of this mirror exercise that focuses on U.S. Treasuries, please see the February 2015 Viewpoint,The Case for Duration in the Long Run.”)

Looking into the future along this mirror-image path, we can estimate the returns of the U.S. credit index – both duration-hedged and unhedged – based on the index yield, duration, spread duration, changes in yields and spreads, as well as historical losses due to defaults and downgrades. We know that U.S. credit has outperformed the equivalent duration-hedged strategy over the period 1999–2014. We estimate this outperformance was about 4% per year based on Barclays’ excess return data. But what about the estimated returns in the mirror scenario? Many would expect the opposite result, but Figure 2 shows that duration hedging again underperformed in this illustration, albeit by a smaller margin. The higher carry earned by the portfolio that held duration more than offset the capital losses resulting from the dramatic yield rise over the period.

Another counterintuitive finding is that duration hedging tends to increase overall portfolio volatility, even though it takes out one of the key portfolio risks, i.e., sensitivity to rising interest rates. The reason for this is diversification: Many factors, such as yields and spreads and – importantly – the correlations among them, drive returns and volatility in a bond portfolio. Portfolio return volatility is a function of volatility of individual risk factors such as credit spreads and interest rates, and negative correlation among them can often dampen overall portfolio volatility. Removing one risk factor can lead to higher overall volatility.

Low duration: a happy median?

Low duration strategies may provide a “happy median” – or a level of interest-rate duration that provides a better trade-off between a full market beta (with interest-rate duration) and a fully duration-hedged beta. Taking the U.S. high yield market as an example, Figure 3 shows the yield and estimated volatility of broad, duration-hedged and low duration indexes. In this case, duration hedging reduces the yield from 5.7% to 4.6% and increases the volatility from 11.9% to 13.1% relative to the broad high yield index. The low duration high yield index, in addition to reducing duration risk, also lowers volatility, and (in this example) actually provides a higher yield as a result of the high yield curve being inverted.

This analysis comparing unhedged, hedged and low duration strategies can be replicated for other fixed income sectors, such as investment grade credit, emerging market debt and inflation-linked bonds (see Figure 4). In all these cases, the yield-to-volatility ratio is most attractive for low duration and least attractive for the duration-hedged strategies.

The volatility numbers shown in Figure 4 are based on history, and one could argue that the initial conditions are materially different now than in years past and historical relationships between interest rates and spreads are less dependable going forward. This is an important point, but PIMCO’s analysis of the current environment suggests the negative correlation between spreads and yields will continue. This means a duration-hedged investment may very well be a costly way to defend a portfolio against rising rates.

The Author

Jeroen van Bezooijen

Product Manager, EMEA Client Solutions and Analytics

Berdibek Ahmedov

Product Strategist, Global and Real Return



Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

The PIMCO Model used as a representation of EM Low Duration Debt is a basket of emerging market securities that mature in or around 2018.  This model was created by PIMCO as a benchmark for EM portfolios managed in a similar strategy. The model does not represent the portfolio characteristics or performance of an actual account. Security selection is based on PIMCO proprietary research and is created with the benefit of hindsight. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.

Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.

Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The Barclays Global Aggregate Credit Index is the credit component of the Barclays Aggregate Index.  The Barclays Aggregate Index is a subset of the Global Aggregate Index, and contains investment grade credit securities from the U.S. Aggregate, Pan-European Aggregate, Asian-Pacific Aggregate, Eurodollar, 144A and Euro-Yen indices.  The Barclays Global Aggregate Index covers the most liquid portion of the global investment grade fixed-rate bond-market, including government, credit and collateralized securities.  The liquidity constraint for all securities in the index is $300 million.  Barclays Global Aggregate Credit 1-5 Year Index is a sub-set of the Barclays Global Aggregate Credit Index. The index is denominated in U.S. dollars. The Barclays World Government Inflation-Linked All Maturities Bond Index measures the performance of the major government inflation-linked bond markets. The index is designed to include only those markets in which a global government linker fund is likely to invest. This makes investability a key criterion for inclusion in the index. Markets currently included in the index (in the order of age) are, the UK (1981), Australia (1985), Canada (1991), Sweden (1994), U.S. (1997), France (1998) and Italy (2003). The Barclays World Government Inflation Linked Bond 1-5yr Index is a sub-set of the Barclays World Government Inflation-Linked All Maturities Bond Index. The BofA Merrill Lynch Global High Yield BB-B Rated 2% Constrained Index tracks the performance of below investment grade bonds of below investment grade bonds of corporate issuers domiciled in countries having an investment grade foreign currency long term debt rating (based on a composite of Moody's, S&P, and Fitch). The index includes bonds denominated in U.S. dollars, Canadian dollars, sterling, euro (or euro legacy currency), but excludes all multicurrency denominated bonds. Bonds must be rated below investment grade but at least B3 based on a composite of Moody's, S&P, and Fitch. Qualifying bonds are capitalization-weighted provided the total allocation to an individual issuer (defined by Bloomberg tickers) does not exceed 2%. Issuers that exceed the limit are reduced to 2% and the face value of each of their bonds is adjusted on a pro-rata basis. Similarly, the face value of bonds of all other issuers that fall below the 2% cap are increased on a pro-rata basis. The index is re-balanced on the last calendar day of the month. The inception date of the index is December 31, 1997. The BofA Merrill Lynch 0-5 Year US High Yield Constrained Index tracks the performance of short-term U.S. dollar denominated below investment grade corporate debt issued in the U.S. domestic market with less than five years remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $100 million, issued publicly. Allocations to an individual issuer will not exceed 2%. The JPMorgan Emerging Markets Bond Index Global is an unmanaged index which tracks the total return of U.S.-dollar-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady Bonds, loans, Eurobonds, and local market instruments. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2015, PIMCO.

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