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Duration Extension Risk and How to Mitigate It


The first month of 2022 was filled with various events that shook the markets:

  • Geopolitical risk climbed with Russia’s saber rattling toward Ukraine
  • Equity suffered significant losses to start the year, including wide intraday swings
  • Growing expectations for rate hikes, tapering and possible balance sheet adjustments from the Federal Reserve caused short and long end rates to climb

Given the meaningful impact such interest rate moves can have on fixed income allocations, we’re revisiting a discussion from nearly a year ago in our April Commentary, with a focus on ways to help mitigate some of the impact.

In that commentary, we examined how the 10-year Treasury yield’s climb from the historic low (0.51%) in August 2020 to the end of April 2021 (1.63%) impacted fixed income markets and changed the characteristics of that market. At the same time, duration measurements across the investment grade fixed income market pushed further out, reflecting the expectation for rates to continue climbing.

As illustrated in Exhibit 1, most subsectors’ duration moved slightly lower but the interest-rate sensitive residential mortgage-backed securities (RMBS) sector more than doubled over the same period, pushing the overall Bloomberg US Aggregate Index’s duration higher, from 6.06 years to 6.27 years at the end of April 2021.

We see in the most recent month-end data that the duration of the overall index continues to extend, with the most significant move once again in the RMBS sector. Since the low point in the 10-year Treasury yield on 4 August 2020, the duration of the RMBS index has climbed nearly 200%, carrying the overall duration of the Aggregate index higher, from 6.06 years to 6.48 years.

Exhibit 1 – 10-Year Treasury Moves & Duration Changes

4 Aug 2020 30 Apr 2021 31 Jan 2022 % change since
4 Aug 2020
10-year Treasury Yield 0.51% 1.63% 1.78%
Duration (years)
Aggregate 6.06 6.27 6.57 7.4%
Treasury 7.28 6.78 6.99 -5.5%
Corporate 8.79 8.45 8.42 -4.8%
Residential MBS 1.57 3.65 4.57 181.2%
Commercial MBS 5.33 5.14 5.04 -5.5%
Asset-backed Securities 2.13 1.95 2.28 6.4%

Source: Bloomberg.

<h4">Duration Impact on Fixed Income Investments </h4">

In our analysis, we used Q1 2021 as an example of the negative impact duration can have in a period of rising rates. In that quarter, the 10-year Treasury yield climbed from 0.91% to 1.74%. January 2022 provided another example of the impact a jump in rates can have over a short period. In January, the yield on the 10-year Treasury climbed from 1.51% to 1.78%. The longer the duration of an asset class, the more significant the impact of interest rate movements on performance, as shown in Exhibit 2.

Exhibit 2 – Duration Impacts on Various Asset Classes

31 Dec 2020
Duration
1Q 2021
Return (%)
31 Jan 2022
Duration
January 2022
Return (%)
Aggregate 6.22 (3.37) 6.57 (2.15)
Treasury 7.21 (4.25) 6.99 (1.89)
Corporate 8.84 (4.65) 8.42 (3.37)
Residential MBS 2.34 (1.10) 4.57 (1.48)
Commercial MBS 5.31 (2.32) 5.04 (1.59)
Asset-backed Securities 2.10 (0.16) 2.28 (0.56)

Source: Bloomberg.

Mortgages

The impact of historically lower rates since 2000 has altered the composition of the mortgage allocation in the Bloomberg US Aggregate Index. As shown in Exhibit 3, the past 20 years have created a mortgage allocation more heavily weighted to historically low coupons. In the analysis we conducted in April 2021, the 2.0% to 3.0% coupon mortgages accounted for roughly 65% of the index-eligible mortgages with the remainder spread between 3.5% to 5.0% coupons (34%) and 5.5% to 7.0% coupons (1%).

Exhibit 3 – MBS Coupon Composition of Bloomberg US Aggregate Index

Exhibit 3

Source: Bloomberg.

Bringing our analysis forward to the current month end, the Fed’s ongoing communication in the latter part of 2021 indicated a tightening cycle was coming, pushing consumers either to accelerate home buying plans to lock in low rates or to refinance. At the end of January, the index composition had shifted dramatically, with 2.0% to 3.0% coupons accounting for the majority (77%) of the mortgages in the index. This is a far cry from the breakdown at the turn of the century when the 10-year Treasury was yielding north of 5% and the MBS index was composed mostly of 5.5% to 7.0% coupons (67%).

What is the impact of this shift? Investors, index funds and managers who rely on plain vanilla mortgages are now in the position of holding mortgages that are at risk of extending even further if the coming Fed tightening cycle pushes longer rates higher. As we’ve discussed, longer duration in periods of rising rates can be painful for fixed income investments.

As we move forward into a Fed tightening cycle, we are faced with a mortgage index, which is poised to extend dramatically as recently originated mortgages will extend further out, and a coupon structure anchored at this historically lower range. We must also consider that as time moves forward and new mortgages are issued at higher rates, those mortgages will gradually be represented in the index.

What Can Investors Do?

One way to mitigate the impact is by utilizing mortgage-backed securities that are structured differently than the benchmark’s plain vanilla mortgages, known as collateralized mortgage obligations (CMOs).

From a credit quality standpoint, there is no difference from to-be-announced (TBA) mortgages and pass-through mortgages issued by government sponsored entities (GSEs)–like Freddie Mac, Fannie Mae and Ginnie Mae–and agency CMOs, as they are all backed by the GSEs.

The difference comes in the structure of the CMOs as well as the variety of securities. With pass-through and TBA mortgages, investors receive a pro-rata share of principal and interest for the mortgages included in the pool. This cash flow process can expose investors to prepayment or extension risk as rates move lower or higher, respectively. (Learn more in the Benefits of Investing in Mortgage-Backed Securities.)

CMOs were originally established as a sequential alternative to the pass-through market, as the cash flows in a mortgage pool were broken into tranches, each with an assumed weighted average life and each not paid until the bond ahead of it was paid off. As the market evolved, so too did the CMO market as investment bankers created more and more types of CMOs to address specific client needs.

The benefit to investors? The ability to find mortgage tranches that can be insulated from the volatlity that accompanies dramatic shifts in interest rates, higher or lower. The various structures available in the CMO market can help a portfolio weather periods of interest rate volatility by providing better convexity compared to pass-through or TBA mortgages. In plain terms, in a period like the first quarter of last year when the duration of the mortgage allocation in the index extended by 1.75 years or 75%, thus exposing investors to even more interest rate risk, the duration on CMOs extended but at a reduced rate.

TBA mortgage: The seller of the mortgage-backed security agrees on a sale price without specifying which individual mortgages will be delivered on the date of settlement. Basic characteristics are agreed upon, such as coupon rate and the face value of the bonds to be delivered but not much else. This process ensures that the TBA market is the most liquid market in mortgages by combining a variety of different pools into a standard format.

Bloomberg US Aggregate Bond Index measures the performance of investment grade, fixed-rate taxable bond market and includes government and corporate bonds, agency mortgage-backed, asset-backed and commercial mortgage-backed securities (agency and non-agency). The index(es) are unmanaged, include net reinvested dividends, do not reflect fees or expenses (which would lower the return), and are not available for direct investment. Index data source: Bloomberg Index Services Limited. See diamond-hill.com/disclosures for a full copy of the disclaimer.

The views expressed are those of the author as of January 2022 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not a guarantee of future results.

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