Restructuring a fixed income portfolio’s duration can be an effective strategy for managing interest rate risk and improving overall portfolio performance. Here are some key steps to follow when considering a fixed income portfolio’s duration.
Step 1: Understanding Duration and Interest Rate Risk
First, it is important to understand the concept of duration and how it relates to interest rate risk. Duration is a measure of the sensitivity of a bond's price to changes in interest rates, and is measured in years. The longer the duration of a bond, the more sensitive its price is to changes in interest rates. Therefore, a portfolio’s value with a higher average duration will be more affected by changes in interest rates. One of the clearest examples of this was 2022 when the Bloomberg US Aggregate Bond Index had a duration around 6 years: the rapid increase in Federal Reserve interest rates drove the Index down 13%.
Step 2: Analyze and Identify the Need
Next, it is essential to conduct a thorough review of the current portfolio to identify the purpose and need of the portfolio This may include analyzing the average duration as it relates to the time horizon of the investor. If the investor does not need the funds in the near-term and can hold the investment to maturity, duration of the individual bonds and that of the portfolio become less important as fixed income matures. However, if the loss of value on a day to day, month to month, or year to year basis is a bigger issue than simple income over the long run, managing duration remains an important step.
Step 3: Develop a Restructuring Plan
Once the current portfolio has been reviewed, the next step is to develop a plan for restructuring duration. This may involve selling some of the longer-duration bonds and using the proceeds to purchase bonds with shorter durations or vice versa. It may also be useful to review the portfolio's yield and credit quality to ensure those are in line with the investor's risk tolerance and return objectives.
Step 4: Consider Credit Quality
When selecting new bonds or sectors to purchase, it is important to consider both the credit quality and duration of the bond. Credit quality is a measure of a bond issuer's ability to pay interest and principal on the bond. Bonds with lower credit ratings are considered to be riskier than those with higher credit ratings, and therefore may be used in a portfolio with a higher risk tolerance, in an effort to increase yield of the portfolio.
Step 5: Restructure, Review and Monitor
Finally, it is important to regularly review and monitor the portfolio to ensure that it remains aligned with the investor's risk tolerance and return objectives. It may also be beneficial to consider diversifying the portfolio across different sectors and maturities to improve the overall risk-return and duration profile of the portfolio. This may include investing in bonds with a mix of maturities, such as short-term, medium-term and long-term bonds, and across various sectors, such as municipal bonds, Treasury bonds, and corporate bonds. Another approach is termed barbell, where a portfolio is balanced between long and short duration to achieve an intermediate duration for the total portfolio. This is something used to address the steepness of the interest rate curve, and balance the need for income, while controlling overall duration.
In conclusion, restructuring a fixed income portfolio’s duration can be an effective strategy for managing interest rate risk and improving overall portfolio performance. You can also see that in many cases managing and restructuring a fixed income portfolio is not a one-time thing, but instead an ongoing process of adjusting a portfolio to the current and expected market, economic, and interest rate environment.
Download our brochure to learn more about Freedom Advisors diversified lineup of fixed income strategies including strategies that take on the management of duration and diversification, as well as specific duration and sector strategies.