Duration as Leverage
Duration in corporate bonds magnifies the impact of changes in credit quality
Lacy Hunt of Hoisington Asset Management has bet since the 1980s on falling interest rates. To maximize the return on that bet, Hunt bought and held the longest-duration bonds he could find. The Wasatch-Hoisington US Treasury Fund currently has a duration of 21.7 and a weighted average maturity of 25.6 years. When 30-year Treasury rates fell from 2.4% to 1.4% in the first six months of this year, the fund returned 24.5%. Duration acted as a form of leverage on Hunt’s bet on falling rates.
When applied to US Treasury bonds, duration is a multiplier for how much a change in rates changes the price of the bond. As the Wall Street Journal helpfully points out in every article on debt, the price of a bond will go up if interest rates fall, and it will go down if interest rates rise.
But interest rates are not all that matters to corporate bonds, and duration doesn’t just magnify interest rate risk. Unlike US Treasuries, corporate bonds bear default risk, and the riskier the bond, the more that credit risk matters. Credit spreads represent about 50% of AAA corporate bond yields, 88% of BB corporate bond yields and 96% of CCC corporate bond yields. For corporate bonds, duration acts as a form of leverage for a bet on changes in credit quality.
Figure 1: Percentage of Yield from Rates and Credit Spread
Source: Bloomberg as 6/30/2020. Spreads are option-adjusted spreads.
Duration is not purely—or even mostly—a measure of interest rate risk for corporate bond investors. It is also a measure of leverage to credit spreads. The price movements of high-yield bonds are dominated by the movements in these spreads, not by movements in Treasury rates. This can be good or bad because credits have idiosyncratic risk. For bonds that might get upgraded, duration is a good thing: lower risk of default leads to lower credit spreads, and returns are magnified by duration.
We can see this in the graph below. Returns for bonds that get upgraded or maintain their rating increase with duration, but duration degrades the returns for bonds that get downgraded.
Figure 2: Returns for BB Bonds by Upgrade/Downgrade Event
Source: Verdad bond database. Data from 1997 to June 2020. Measurement period for returns and upgrade/downgrade events is one year.
This is well understood in lending markets, and it is one reason that investment-grade companies can issue longer-dated debt while riskier companies can usually only access shorter-dated or even floating-rate debt. Lenders to riskier companies do not want to leverage their risk and prefer to lend short and take their return from interest payments. As a result, there is a tradeoff between duration and credit risk. Investors seeking to avoid duration will often select into credit risk.
In our view, duration just magnifies the dominant driver of return. In Treasuries, that is interest rates. In investment-grade credit, that is interest rates and credit spreads. In high yield, that is mostly credit spreads. Duration is therefore leverage to credit picking, and if you believe that you have some advantage in picking credit, then duration can be a cheap form of leverage.