match-g7dcaa40e3_1920

Should you use duration matching?

We’ve made it!

This is the final post in the series on duration matching.

Before we conclude, let me explain what we’ve seen so far.

No, there is too much. Let me sum up.

Duration matching makes it possible to eliminate interest rate risk in your bond portfolio by matching the duration of your bonds to your investment horizon. It doesn’t matter what interest rates do between now and then – as long as your duration matches your time horizon, your price risk and reinvestment risk cancel each other out, and you have zero interest rate risk.

In fact, by not matching your duration to your investment horizon, you’re taking on interest rate risk.

If you have a long investment horizon, but a short bond duration, you’re taking on more reinvestment risk and less price risk.

If you have a short investment horizon, but a long bond duration, you’re taking on less reinvestment risk and more price risk.

Matching the investment horizon to the bond duration (i.e. both are short or both are long) means you’re allowing those risks to cancel each other out – you’re taking no interest rate risk.

For investors with long time horizons, the use of long-term bonds can not only can substantially reduce your interest rate risk, but they come with the added benefits of being able to reduce drawdowns and increase long-term returns. Granted, the drawdown-reduction benefit over shorter-term bonds isn’t guaranteed, but history suggests the odds are good. In the instances where the drawdown-reduction benefit wasn’t better than shorter-term bonds, it was only marginally worse. And given their much higher long-term returns, it looks like a pretty good trade.

But an intermediate-bond strategy also has its advantages when compared to duration-matching.

  • Intermediate-term bonds are a happy medium between a risk-reducer and a diversifier.
  • Compared to cash, they’ll have larger drawdowns, but will also provide better protection when equity markets fall. Compared to long-duration bonds, they won’t provide the same level of oomf in a crash, but they won’t have the drawdowns either.
  • Compared to duration matching, an intermediate-bond approach has the advantage of being ‘set-and-forget’, doesn’t require any forecasting of future expenses, and might be easier to stick with.

So what’s the deal? Should we use duration matching or just stick it all in intermediate-term bonds?

 

Final thoughts on duration matching

 

For every risk an investor faces, there’s almost certainly a strategy they can employ to address that risk.

If the risk is interest rate risk, the best strategy is probably “duration matching”.

If the risk is inflation risk, the best strategy is probably “inflation-linked assets”.

If the risk is credit risk, the best strategy is probably “government bonds”.

If the risk is longevity risk, the best strategy is probably “income annuities”.

It would be almost impossible (and prohibitively expensive) to neutralise all those risks at once. But there are strategies to deal with each of them – some of which can be combined to address multiple risks together.

For example, investors who face inflation risk should address that risk by using inflation-linked bonds. Investors who face interest rate risk should use duration matching. Investors who face both risks should do both!

Duration-matching is a specific lever for neutralising interest rate risk. It doesn’t neutralise inflation risk, credit risk, longevity risk, or any other risk. If you face those risks as well, then you’re going to need to employ other strategies in addition to duration-matching. Matching your bond duration to your investment horizon is an important part of making sure you aren’t taking on more risk than you need to, and that you’re compensated for the risks you are taking.

One of the many great things about being a DIY investor is we can tailor our portfolio to suit our own needs, circumstances, and personality. Duration-matching is something you’d never get from a professional investment manager. It’s far too tailored – this is only something us DIY investors are able to do. But whether or not you choose to adopt a duration-matching approach depends largely on you.

For investors who want a completely ‘set-and-forget’ approach, and don’t want to take on any additional faff with their portfolios, then an intermediate-term bond approach is absolutely fine. It’s a great balance between a risk-reducer and diversifier, and it’s guaranteed to never be the absolute worst option in hindsight – which is hugely valuable. It’s the default option for a reason.

Equally, for those investors who can’t help but look at individual positions rather than the holistic portfolio, and know they’re liable to switching out underperforming funds, then intermediate-term bond funds are also the way to go. Using intermediate-term funds is a much better option than trying to hold long-duration bonds, before selling them the worst point possible. Use intermediate-term bonds if you need to save you from yourself.

(This argument only applies for investors with a long time horizon. If your investment horizon is short, then you might as well be buying short-term bond funds anyway – they’re less volatile and their shorter duration will be a closer match to your short investment horizon.)

For those who don’t mind a bit of extra legwork, and who are able to stomach the drawdowns of longer-term bonds, then duration matching is a great approach.

By accepting the additional behavioural risk and the extra administrative faff of duration matching, long-term investors are able to meaningfully reduce interest rate risk, improve diversification, and generate additional returns compared to using intermediate term bonds. For those with shorter-term investment horizons, duration matching reduces the risk of interest rate rises lowering the value of your bonds and you not being able to meet your liabilities.

And remember: duration matching doesn’t need to be perfect.

Nobody can be expected to perfectly forecast the timing and amount of their future cashflows. But this approach doesn’t require precision, it only requires some sensible guesswork (which is all investing is anyway).

So whether or not you should be using duration-matching depends on who you are as an investor. Intermediate-term bonds are a great option for those who either pay absolutely no attention to their portfolio, or who pay too much. For those able to tread the middle ground, for those those who don’t mind a bit of extra legwork, and for those who are able to resist the temptation to performance-chase, the advantages of duration matching make it a great approach.

Share on Facebook
Share on Twitter
Share on LinkedIn

Past performance does not guarantee future performance and the value of investments can fall as well as rise. The information on this site is provided for information only and does not constitute, and should not be construed as, investment advice or a recommendation to buy, sell, or otherwise transact in any investment including any products or services or an invitation, offer or solicitation to engage in any investment activity. Please refer to the full disclaimer on the disclaimer page.

Subscribe
Notify of

3 Comments
Newest
Oldest Most Voted
Inline Feedbacks
View all comments
Seoras
April 3, 2022 5:56 pm

Thanks for your all articles on bonds – the clearest and most digestible writing I have found on this subject. For me the articles reinforce my bias that coming up with a DIY bond portfolio is a non trivial exercise. So I wonder what you would think of novice investors using LifeStrategy 20% as an alternative to a DIY blend? Then you get the 80% blend of bond funds managed by Vanguard’s algorithms. When I look at the bond funds inside LifeStrategy 20% I see some of the things you like (global government bonds, UK index linked gilts) and some you don’t (corporate bonds) but overall I wonder if it offers a reasonable alternative providing some crash+inflation protection and for simpletons like me.

Last edited 4 months ago by Seoras
Alexander
March 29, 2022 9:13 am

Great post as always. Please can you suggest some widely available passive / cheap Bond funds that have different durations, I have struggled to find these on my low cost platform. Thanks