Trend Check with Tushar Chande

Back to Basics: Understand the Duration of Your Bond ETF or Bond Clone

The declines in global bond markets this week points out the need to be aware of your bond ETFs duration, which measures the sensitivity of the bond or ETF to changes in interest rates.  Duration is expressed in years, and the longer the duration, the greater the change in the price of the bond (or bond ETF) for a given change in interest rates.  You may also own bond clones, or ETFs which are closely linked to the bond market, such as an ETF with utilities.  Since such funds have stocks, there is no way to  know their effective duration.  I looked at the universe of Vanguard bond ETFs to illustrate the effect of bond duration, as well as to estimate the effective duration of bond clones.  As central banks work to nudge rates higher, you should be aware of the duration of your bond portfolio. 

Chart 1:  The duration of the Vanguard bond ETFs versus their recent performance, with declines increasing with longer duration. The key to symbols is shown below.


 

Longer the Duration, Larger the Price Drop As Rates Rise

 

In broad terms, as rates rise, the longer the duration, the larger the price declines. You can see this clearly in Chart 1.  The duration of the Vanguard Extended Duration Treasury bond ETF is 24.7 years, but the duration of BND, the Vanguard Total Bond Market ETF is just 6.5 years.  Over the past five days, when EDV dropped -2.4 percent,  at the same time, BND declined just -0.39 percent.  Thus, longer duration means greater price declines as rates rise. Hence, you should look past the name of the bond ETF and look up its effective duration.

 

Estimating Duration of Bond Cousins

It is impossible to know the duration of some bond cousins and clones because they invest in stocks that are closely tied to the bond market, such as utilities.  I fitted the 10-day declines to a regression, and then converted the observed declines into the equivalent bond duration for several Vanguard clones like the Utilities ETF (VPU) and REIT ETF (VNQ) (see Chart 2).  This chart is useful for planning purposes because it gives you a calibration of the sensitivity of a particular bond clone to the equivalent bond.  Naturally, these numbers are not cast in stone, but will vary over time.  Their value is in able to gauge the impact of rising rates on  potential price moves.

 

Chart 2: I fitted the 10-day declines in Chart 1 to a linear regression, and then used the observed declines in bond clones such as VPU and VNQ to find the equivalent duration.  By definition, stock-based ETFs do not have any duration, but this calibration is a "rule of thumb" for estimating their current sensitivity to interest rates.  Naturally, this sensitivity will vary over time.  The key to symbols is shown below.

 

Chart 3:  Key to symbols used in Charts 1 and 2.

 

Know Your Bond ETFs Duration

The vendor websites of bond ETFs show the effective duration data.  You should keep it in mind as central banks around the world begin to nudge rates higher, and markets react with varying degrees of alarm to these actions.  It is also useful to know how your bond clones are reacting to the bond market movements of their equivalent duration.

Thank you for tuning in, and please subscribe to this blog below.

Tushar

 

 

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