In a late-cycle, rising interest rate environment, duration can be overlooked. But looking at the bond market today, might it be worth giving duration a second chance? The answer, surprisingly, is yes. Investors would be right to question this: “But the Fed is raising rates!” you might say; “Growth and inflation in the U.S. are heating up!” And yet despite these things both being true, there are two reasons to nonetheless revisit duration.
First, yields might not have much more room to climb. While yields have not sky-rocketed, and by historical standards seem low, they have increased substantially from when the 10-year Treasury yield troughed in July 2016. Even with the Fed on course to continue increasing rates, the downward pressures on the long end of the yield curve – foreign inflows and structurally lower growth and inflation overseas – are not poised to disappear. Capital depreciation has been a headwind for fixed income investors as a result of rising yields, but thus far in 2018 it has been relatively tame. In the longer run, higher yields will benefit all bond investors.
Second, duration helps to shield investors from stock market volatility and a recession; both of these things are inevitable, especially given our position in the cycle. While there is no imminent recession in sight and growth has picked up in the face of fiscal stimulus, trade war worries, political jitters and rising rates imply that duration may have a renewed place in a portfolio.
For long-term investors in fixed income, rising rates implies short-term pain for longer-term gain. Higher yields from fixed income and late-cycle protection imply duration deserves a second look.
Rising yields from 10-year nominal Treasury yield low
Source: Bloomberg, Barclay's, FactSet, J.P. Morgan Asset Management. *Yields are yield-to-worst. US TSY represents the Barclays US Aggregate Government - Treasury (1-4Y) Index.