Attention fixed income investors: Let's talk about duration extension


  • The interest rate exposure within the Barclays U.S. Aggregate Index — also known as its duration — has evolved with changes in its underlying sectors. 
  • Since 2009, the yield and coupon profile of the index has compressed, while its duration has extended. 
  • This represents an asymmetric risk-reward balance, because over longer time horizons, coupon returns drive the majority of total return.

The Barclays U.S. Aggregate Index is a broadly based, widely followed index of fixed income markets, based on a market-cap-weighting of investment grade bonds traded in the United States.

Since its inception in 1976, the index has evolved along with the development of various fixed income sectors, taking into account their embedded duration and issuer concentration profiles. For example, as asset-backed securities (ABS) became more popular, these were included in the index in 1991, followed by commercial mortgage-backed securities (CMBS) in 1997. The table below illustrates how the composition of the index has changed during the past 30 years.

  1980 2014
U.S. Treasurys 35-45% 35.7%
U.S. IG corporates 45-60% 23.1%
U.S. MBS 5-15% 29.1%
Government-related   9.9%
CMBS   1.7%
ABS   0.5%
IG = investment grade
MBS = mortgage-backed securities
CMBS = commercial mortgage-backed securities
ABS = asset-backed securities

As shown, issuance trends — the emergence of new sectors and their underlying duration and concentration profiles — have shaped the index since its inception. However, let’s focus on the more-recent evolution of the index, in particular its duration profile since 2009 (see Chart 1).

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Barclays U.S. Aggregate Index: duration versus average coupon and yield

Chart 1. Barclays U.S. Aggregate Index: Duration versus average coupon and yield

Chart shown is for comparison purpose only

The data illustrate considerable duration extension within the index, while its yield and coupon have experienced some compression. For investors benchmarked to the index, this means taking more interest rate risk (in the form of duration) in exchange for smaller future rewards (yield). At this writing, the index’s current yield of 2.23 and its duration of 5.66 imply that an interest rate increase of 39 basis points would wipe out the yield component of total return. (One basis point equals one one-hundredth of a percentage point.)

A closer look at the relationship between duration, coupon, and yield can help explain why bonds with high coupon rates and, in turn, high yields will tend to have lower durations than bonds that pay low coupon rates or offer low yields. It makes sense because when a bond pays a higher coupon or has a high yield, the holder of the security receives repayment at a faster rate. Chart 2 summarizes this relationship.

The relationship between yield, coupon and duration

Chart 2. The relationship between yield, coupon and duration

Because yield and duration are the key drivers of total return for a bond investment, it is interesting to look at the yield-versus-duration relationship historically, as plotted on Chart 3.

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Barclays U.S. Aggregate Index: Yield to worst vs. duration

Chart 3. Barclays U.S. Aggregate Index: Yield to worst vs. duration

Chart shown is for comparison purpose only

Based on this metric, the risk-reward associated with index-based investments is asymmetric. Another way to think about this is that over the same time frame, the annualized total return for the index was 6.83%, while the average coupon rate was 6.37%, which implies that over long periods, the coupon component represents the majority of total return (in this case, 93% of total return). Apply this concept to the index’s current coupon of 3.32%, and you see the index’s reward potential in today’s environment.

Chart 4 examines each sector within the index to isolate the source(s) of the index’s duration extension.

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Barclays U.S. Aggregate Index: Amount outstanding by sector

Chart 4. Barclays U.S. Aggregate Index: Amount outstanding by sector

Chart shown is for comparison purpose only

Compared to 2009, the amount outstanding has increased in Treasurys and investment grade corporates, while the amounts of MBS and government-related debt have shrunk. At the same time: (1) the average maturity has remained stable in Treasurys; (2) ABS and CMBS have shown contraction; and (3) government-related, investment grade corporates, and MBS have shown extension. We also note that the average coupon rate has compressed across sectors as new-issuance refinancing has occurred at lower yield levels. In terms of contribution to duration, Treasurys, investment grade corporates, and MBS have extended the most.

A word about MBS durations, and a closing note

Lastly, we want to focus on the duration dynamics of MBS. Refinance waves (represented in Chart 5 by the Mortgage Bankers Association Refinance Index) have led to the creation of “new” MBS securities that carried lower coupons and longer durations. These securities were then included in the index, extending its overall duration (Chart 6).

In light of the evidence mentioned thus far, we conclude that the risk-reward scenario created by the current interest rate environment is unattractive for investments that mirror the Barclays U.S. Aggregate Index. Across the portfolios we oversee at Delaware Investments, we therefore advocate the diversification of income strategies versus interest rate risk (spread over duration), which we believe can offer a degree of protection from downside risk and potentially achieve a reasonable return on (and of!) capital.

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U.S. MBS duration and refinance activity

Chart 5. U.S. MBS duration and refinance activity

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U.S. MBS duration profile: Significant extension since 2012

Chart 6. U.S. MBS duration profile: Significant extension since 2012

Chart shown is for comparison purpose only

Chart shown is for comparison purpose only

The views expressed represent the Manager's assessment of the market environment as of June 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.