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Wealth Management

To Extend or Not to Extend Duration, One Must Pick a Side

Navigating the tricky bond investment landscape, Catherine Reichlin explores the dilemma between extending or not extending the duration. Said differently the dilemma between embracing interest rate risk or reinvestment risk in an unclear economical scenario.

To extend or not to extend the duration, that is the question plaguing bond investors. In other words, is it better to take an interest rate risk or a reinvestment risk at this time? The former can lead to significant losses. 2022 is the best illustration: the sharp increase in bond yields generated a 12% loss for US Treasury bonds. A global figure that hides massive disparities: -5.5% for maturities of 1-5 years but... -25% for maturities of 10-20 years.

Put differently, interest rate risk implies a probability of loss. Reinvestment risk, on the other hand, is estimated with a probability of missed profit. It is this risk that has penalized bond investors for a decade: having to reinvest maturing bonds at ever-lower and then negative yields.

"Interest rate risk implies a probability of loss. Reinvestment risk is estimated with a probability of missed profit." The choice of risk-taking will depend on the investor's scenario for the coming year: recession or not, control of inflation or not, end of the rate hike cycle or not. The evolution of the US yield curve in June signals fears of a recession with a controlled inflation and the end of the rate hike cycle. The curve has continued to invert, and the 10-year maturity now yields 1% less than the 2-year rate (3.75% versus 4.75%).

At the beginning of June, the inversion was only 0.75%. A market signal that estimates that the probability of further rate hikes in the United States is receding: not only is it now only 25% for this fall, but it is already 50% for... a decrease in January! A scenario that advocates for buying duration and also implies having to take a less well-remunerated risk: buying a bond with a 2-year maturity still yields 1% more than a 10-year maturity bond.

Seeing this as a "missed profit" is tempting but it is a short-term view, because in two years, nothing can say that investors will be able to reinvest at this level, or even at the current maturities at 10 years. That being said, it is understandable to see this as missed profit. This is why many investors favor quality corporate bonds that yield more than government bonds. Investment-grade bonds with 7-10 year maturities yield on average 5.30%, significantly more than the 10-year Treasury (3.75%) and even the 2-year Treasury (4.75%). A calculation also made by bond issuers who know that demand is high.

Between the last meeting of the Federal Reserve on June 15 and June 21, more than $16.7 billion has been issued on maturities of 7 years and longer through 74 bonds. The 10 to 20-year segment represents 60% of the amount issued and financial companies took the lion's share with more than 50%. A boon for investors willing to extend duration and who remember more the last decade than the last year and believe that a bird in the hand is worth two in the bush.

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