Most investors know they can take on too much risk, but very few probably realize they can take on too much safety.
With this year’s volatility in global markets, municipal bond ETFs appear to be benefiting from “flight to safety” flows, with assets under management up more than 4% (through Feb. 10). Because municipal bonds are generally viewed as a so-called safe investment, it is not surprising that investors are shifting some of their assets into muni ETFs, with a significant percentage of that money going into the “safer” low-duration muni ETFs.
However, there are risks of using only low-duration muni ETFs.
As with other types of investments, it is impossible to eliminate all the risks of investing in municipal bonds because reducing some risks can mean increasing others. In some cases, taking on less investment risk may mean reducing the ability to achieve an important future goal. In other words, some investments can be too safe.
Managing a portfolio is about balancing risks against the potential for return and the investor’s goals.
For example, many investors have favored short-duration ETFs in order to avoid taking on too much interest rate (or market) risk, perhaps not realizing they are increasing their reinvestment risk. Being able to make an informed judgment about how much reinvestment risk to take on requires an understanding of how much market risk you are taking on.
Duration is the mathematical tool used by professional portfolio managers as an indicator of how much market risk there is in a particular bond or portfolio. The calculation is based on time until maturity, call features and coupon rate, and estimates market price volatility when interest rates move.
Because duration takes into account bond coupons as well as maturity, it is a better indicator of a bond’s market-price sensitivity (as yields change) than maturity or “priced to date” alone. As it is used commonly, duration most often refers to modified duration, although there are two different calculations for duration:
- Macaulay duration is the average weighted maturity of the present values of a security’s cash flows. Quoted in years, this calculation is now rarely used. Macaulay duration can be helpful to rank bonds based on relative volatility, but is less helpful in understanding the impact of interest rate changes on a bond or a portfolio.
- Modified duration is the estimated percentage change of the price of a security for an immediate 1% change in yield for the entire yield curve (known as a parallel shift in yields) and is the calculation most commonly used by professional portfolio managers. A bond (or an ETF) with a modified duration of 5.0 would be expected to decline in market value by 5% if rates immediately moved higher by 1%. The reverse would also be true—if rates decline by 1%, then that hypothetical bond (or ETF) would be expected to move higher in value by 5%.
With both calculations, the larger the number, the greater the expected change in market price when rates move. (For the rest of this article, and as is standard in the industry, duration will refer to modified duration.)
To calculate the duration for a portfolio or an ETF, the duration for each of the individual bonds in the portfolio is calculated, and then weighted to come up with the duration for the overall portfolio. Because it is only an estimate of the change in market price, using duration as a guide to volatility has its limitations. Changes in prevailing market conditions will affect the actual price movement of individual bonds differently. However, duration is an excellent tool for comparing different bonds or portfolios.