Duration = Risk

For many years RBA’s fixed-income holdings had substantially longer duration than that of our benchmark. Today, our holdings have only a fraction of the benchmark’s duration. Our portfolios’ bond durations are now only about 15- 20% of benchmark duration versus the 200% of benchmark duration we held for the earlier part of the decade.

Although flows into bond ETFs and funds have been strong, short duration bonds seem to be relatively out of favor versus longer duration bonds. Chart 1 highlights that the iShares 20+ Year Treasury Bond ETF just had its largest monthly inflow ever.

Investors may be underestimating the risks associated with longer duration fixed-income. Investors continue to focus on equity market risk and volatility, but they seem oblivious to the risks in long duration fixed-income.

The long end of the yield curve appears historically overvalued

Determining an asset class’s valuation is always questionable. Changes to inputs, time horizons, and various assumptions can significantly change valuation conclusions. If valuation is truly extreme, however, the choice of valuation model and inputs often doesn’t alter the conclusion. In those cases, the asset class appears overvalued regardless of the inputs or model.

This extreme situation appears true today at the long end of the yield curve. There are numerous models that attempt to compare the relative attractiveness between short duration and long duration bonds, and today they are all signaling that the long end of the yield

curve is overvalued. The term premium is a measure that can be used to compare the attractiveness of fixed-income strategies by maturity. For example, the most common measure of the term premium compares the expected return from buying a 10-year note to that from buying a 1-year note in anticipation of rolling it over ten times.