Fixed income ETF investing: Bond duration and its impact on your portfolio

For fixed income investors, navigating interest rate fluctuations is crucial, as bond prices typically move inversely to interest rates. For example, a bond with a duration of five years might experience a price change of approximately 5% with a 1% shift in interest rates. Understanding duration can empower investors to anticipate and respond to market movements.

Duration is not just a tool for estimating price changes; it can also serve as a benchmark for comparing various bonds, or bond ETFs.  Innovation in the fixed income ETF space means that there is a range of segmented fixed income solutions based on credit quality, geography and you guessed it, duration. Investors can position their portfolios across the yield curve to capitalize on expected shifts tactically using ETFs. However, it’s important to recognize that duration has its limitations. It operates under the assumption that interest rates will change in a uniform manner across the yield curve², which is often not the case.

Additionally, duration assumes a linear relationship between bond prices and interest rate changes, overlooking the effects of larger interest rate shifts and the concept of convexity — the curvature of the relationship between bond prices and bond yields which reflects the rate at which the duration of a bond changes as interest rates move. While duration can effectively guide smaller interest rate movements, it may falter under more significant fluctuations.

Furthermore, duration is primarily useful for assessing short-term interest rate risk and does not fully address long-term factors such as credit quality changes or macroeconomic influences that can impact bond prices. Special features in certain bonds, like embedded options or callable features, can also complicate the accuracy of duration as a price sensitivity measure.

When we talk about “adding duration,” we refer to selecting bonds, or bond ETFs, with longer maturities, while opting for short-term maturities would decrease duration. Whether to extend or shorten duration hinges on your outlook for interest rates. For instance, if you anticipate falling interest rates, longer-duration bond ETFs may provide greater potential gains as their prices are likely to rise more significantly than those of shorter-duration bond ETFs. Balancing duration can also enhance portfolio diversification, aligning risks with returns.

Another aspect to consider is the yield curve, which plots different interest rates over varying maturities. An inverted yield curve, where long-term rates are lower than short-term rates, suggests that investors expect short-term rates to decline in the future. Historically, prolonged inversions have been rare, and the current trend indicates market anticipation of rate cuts and lower inflation ahead. Eventually, a return to a more traditional upward-sloping yield curve is expected.

Investors may consider Target Maturity Bond ETFs which offer the predictability of a bond with the flexibility of an ETF. Target Maturity Bond ETFs combine the benefits of traditional ETFs—such as diversification and liquidity, with the advantages of bonds such as defined maturity, and reduced duration risk³ over time.

These ETFs have varying maturity dates to choose from, so investors can build a tailored fixed income portfolio aligned with their investment goals and time horizon.

Understanding duration is pivotal for bond investors looking to navigate the complexities of fixed income markets. By leveraging duration effectively, investors can position their portfolios to respond to interest rate changes, balancing risk and return in pursuit of their investment goals. Whether you’re a seasoned investor or just starting out, mastering the concept of duration can enhance your approach to bond investments.

ETFs have simplified fixed income investing, segmenting the market by short, mid and long duration products making it much more efficient for investors to position themselves tactically along the curve.