When Duration Goes Negative

Question: I've noticed that some bond funds have negative effective durations [a measure of interest-rate sensitivity]. How is this possible, and does it mean these funds will increase in value if interest rates rise?

Answer: As we've discussed previously in The Short Answer, duration is a metric often used to gauge how a bond or portfolio of bonds will react to changes in interest rates. With so much attention being paid these days to when the Fed will begin raising rates, it's no wonder we've been hearing a lot about duration, as well.

The basic rule of thumb for using duration says that for every percentage point that rates move up or down, a bond can be expected to move in the opposite direction by a percentage equal to its duration in years. So if rates go up 1 percentage point a bond with a duration of 5 years would be expected to lose 5% of its value. The longer the duration, the more sensitive the bond is to interest-rate fluctuations. For bond funds an average duration is calculated using an asset-weighted formula based on the bonds held in the portfolio. Morningstar uses a form of duration called effective duration, and the fund companies report the duration statistics found on Morningstar.com's fund pages. (Not all funds have reported this information.)

Although duration is useful as a gauge of interest-rate sensitivity, it isn't a perfect one. In particular, duration works best when comparing the relationship between bonds that are similar in type and not so well for bonds of different types. So the average effective duration metric is likely to be a more reliable measure of how a fund that holds primarily government bonds would react to a rise in Treasury rates than it would be, say, for a fund that holds primarily high-yield corporate bonds.

Cutting Down on Exposure
Many bond-fund managers have been shortening their funds' average durations in an attempt to blunt interest-rate sensitivity. One way to do this is simply to increase the fund's exposure to bonds with shorter maturities. But another method involves the use of derivatives such as interest-rate swaps, interest-rate options, and Treasury futures. (For more on derivatives, see this Short Answer column). 

To illustrate how a bond fund might use Treasury futures to reduce its exposure to rising interest rates, consider that if you purchase a Treasury futures contract you're taking on just about the same interest-rate exposure as the underlying bond. But if you sell a futures contract, you are gaining interest-rate exposure that is the opposite of the underlying bond. So by selling Treasury futures a bond fund can gain this inverse exposure to Treasuries. "If you sell enough contracts you could actually sell enough to take the duration negative," says Eric Jacobson, a Morningstar senior fund analyst who specializes in fixed income.

Many bond funds--in particular those holding lots of short-term securities--have average effective durations of 1 year or less (and floating-rate funds often have durations very close to zero). But a handful of funds have effective durations that venture into negative territory. Morningstar's database includes three funds that reported having negative average effective durations as of their most recent portfolio reports. They are Scout Unconstrained Bond (SUBYX) (negative 2.70 years),  Putnam Diversified Income (PDINX) (negative 0.23 years), and Eaton Vance Global Macro Absolute Return Advantage (EGRAX) (negative 0.04 years). 

Duration Just Part of the Story
In theory a bond fund with a negative average duration should appreciate in value if interest rates rise. But fixed-income investors seeking protection from a rise in rates shouldn't consider duration alone in choosing a fund. Knowing what's in the portfolio is just as important. For example, a fund that holds lots of low-quality corporate bonds, which don't necessarily move in lockstep with Treasuries, may have an average effective duration that is less reliable as a measure of its sensitivity to Treasury-rate changes than that of a fund that holds primarily government bonds. Also, a fund with a low or negative duration but that owns a lot of junk bonds could expose investors to a different kind of risk--credit risk--if the market turns against low-quality fare.

Jacobson says bond-fund investors who have ignored factors other than duration amid all the hand-wringing over rates could be in for a rude awakening. "To the degree that people are concentrating totally on duration and not on what else is in their portfolios, there are going to be some surprises," he says.

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