Bond Fund Duration: An Art, Not a Science
Duration can provide guidance, but not certainty.
The financial crisis and the resulting market shocks had a number of surprising consequences, most of which continue to dominate headlines. One that was particularly important to bond investors, though, was the degree to which diversified bond funds struggled or lost money, even though cash flowed to Treasury bonds. Take the long-term government and long-term bond categories. Most of the time the funds in these two groups are expected to have pretty similar risks--they both focus on bonds with long maturities and relatively high-quality debt. Yet the divergence in their 2008 performance was breathtaking: The average long-term government fund gained nearly 28%, while the average portfolio in the long-term bond category--funds that hold mostly nongovernment investment-grade bonds--fell by more than 3.7%. Why?
In 2008, when investors the world over piled into Treasury bonds--and almost exclusively Treasury bonds--long government-bond funds were the beneficiaries. Other long-term investment-grade bonds and funds were not similarly rewarded. Fears about the broad economy and the very future of the financial sector prevented nongovernment funds from rallying.
Under normal circumstances, portfolios' effective durations would have provided guidance about how those funds would respond to Treasury market shifts. Funds in both categories have occupied a wide range of duration territory, but nothing about the dispersion of their durations would have suggested such an extremely broad span of returns. And if that weren't odd enough, a nearly inverse phenomenon occurred as the market snapped back in 2009.