Week 22 Day 6: Duration: Your Bond Portfolio's Risk Dial

Duration is measured in years but think of it as a risk dial. Turn it up (longer duration) for more price sensitivity. Turn it down (shorter duration) for stability. BND has a duration of about 6 years. SHY (short-term Treasuries) has a duration of about 2 years. TLT (long-term Treasuries) has a duration of about 17 years.

Duration-matching to your investment horizon eliminates interest rate risk. If you need money in 5 years, buy bonds or bond funds with a 5-year duration. Over that period, any price decline from rising rates is offset by reinvesting coupons at higher rates. The crossover point equals the duration. Practical duration choices: Ultra-short (0-1 year): SGOV, BIL. Almost zero rate risk. Yields track the Fed funds rate. Good for emergency funds. Short (1-3 years): SHY, VGSH, SCHO. Minimal rate risk. Stable price. Good for money needed in 1-3 years. Intermediate (4-7 years): BND, AGG, SCHZ. Moderate rate risk. The standard recommendation for the bond portion of a diversified portfolio. Long (10-30 years): TLT, VGLT, EDV. High rate risk. Maximum gains when rates fall, maximum losses when rates rise. Good for speculative rate bets or for retirees with very long horizons who want maximum income. The 2022 lesson: investors who held TLT (duration 17) lost 30%+. Those who held SHY (duration 2) lost about 4%. Same asset class, vastly different outcomes, entirely determined by duration.

The distinction between Macaulay duration (the weighted average time to receive cash flows, measured in years) and modified duration (the percentage price change per unit yield change) is important for precision. Modified duration = Macaulay duration / (1 + y/n), where y is the yield and n is the compounding frequency. For most purposes in portfolio management, modified duration is the relevant measure. Effective duration extends the concept to bonds with embedded options (callable bonds, mortgage-backed securities) where cash flows are uncertain. The BND portfolio's effective duration (approximately 6.2 years) is lower than its Macaulay duration because it includes MBS (mortgage-backed securities) with prepayment optionality. Key duration applications: (1) Immunization: matching portfolio duration to liability duration neutralizes interest rate risk. This is the core of pension fund management and applicable to individual decumulation planning. (2) Barbell vs. ladder vs. bullet: three strategies for structuring bond maturities. Barbell (mix of short and long) provides optionality. Ladder (equal maturities at regular intervals) provides predictable cash flows. Bullet (concentrated around a target date) minimizes reinvestment risk for a specific obligation. (3) Duration extension as a return-seeking strategy: the term premium (approximately 0.5-1.0% historically) compensates investors for bearing interest rate risk. In the current environment with an inverted or flat yield curve, the term premium is approximately zero or negative, meaning long-duration bonds are not compensating investors for the additional rate risk.