Duration Drift

Article excerpt

Measuring fluctuations in your bond portfolio

Having experience at advising community bankers about the fundamentals of running a bond portfolio, I am aware of the more pertinent factors about which a manager is concerned, specifically as they relate to day-today buying. Namely yield, maturity date, credit quality, liquidity and callability.

The credit criterion usually doesn't get a lot of discussion because most securities in a bank's portfolio are either issued by a government agency or are insured, resulting in a AAA rating by Moody's, Standard & Poor's or both. Liquidity can be an issue, especially if credit quality is less than AAA or block size is below "round-lot" (which varies from product to product). There is usually careful attention paid to the maturity/call date/average life factor, since most banks have defined limits in their investment policies.

Yield, I think we can agree, is probably the most discussed variable and does, in fact, get a lot of attention during a sales presentation.

What is interesting about these practices is that once a decision has been made to buy a bond, a number of the characteristics of that bond are no longer closely followed, even though they may change during the life of the bond. The most obvious example is once again yield, especially if a bond has a floating rate.

Change as a Constant

One variable that is absolutely certain to change, however, is a bond's duration. By way of review, remember that a bond's duration is really two, interrelated factors. It is the weighted average period of time for the receipt of all principal and interest on a bond, and it is also a measurement of the price volatility of the security in a plus or minus 100 basis point scenario. For example, if a bond's duration is 2.5, it will take an average of 2.5 years to receive all the P and I on the bond; it will also lose 2.5 percent of its value if rates rise 100 basis points today.

Since the weighted average period of time for the receipt of all P and I is constantly changing, whether or not interest rates themselves change, the management of a portfolio's duration truly requires constant attention, not unlike a farmer studying weather and moisture patterns. Bonds also don't have their durations change consistently. For example, a non-callable (bullet) bond will contain the "roll down yield curve" properties, while an amortizing security (like a mortgage- backed security) will have a duration profile that is much less linear.

Average Duration Swings

The last five years have produced some dramatic yield swings and some yield levels that had been unseen for a generation. A review of average portfolios at the highs and the lows of the past halfdecade can help determine how much duration "drift" has been experienced.

The sample for our analysis is the roughly 500 banks that use Vining Sparks for their bond accounting services. The average portfolio in this group is about $61 million, so it is fair to call them representative of community bank portfolios generally.

The starting point for this analysis is June 30, 2000. Recall that Fed Funds peaked at 6.5 percent that year, and the Treasury curve across the board yielded roughly the same. …