Bond volatility: with rates elevated, duration matters

Interest-rate volatility continues to be a major concern for many fixed-income investors. In this weekly edition of Simply put, we examine the treacherous relationship between the volatilities of interest rates and bond returns.

Interest-rate volatility vs bond volatility

Higher interest-rates volatility has popularised specialised quantitative investment strategies run by investment banks, and we are convinced that these are still useful today. But it has also strongly influenced our risk-based views, leading us to favour cash over bonds. However, it remains important not to confuse interest-rate volatility with bond-return volatility. 

As we discussed last week, interest-rate volatility could remain at high levels for the time being, reflecting increased demand for hedging against interest-rate risk, as well as the natural consequences of higher rates themselves. However, we must be careful not to confuse the volatilities of interest rates and bond returns. Figure 1 compares these two metrics, showing that while the two are generally correlated, this relationship remains imperfect – particularly when interest-rate volatility is high. 

For example, when interest-rate volatility is around 1.3%, the volatility of an aggregate bond index can lie between 5% and 9%, i.e., a ratio ranging from close to 1:2. The interest rate volatility seen in October (around 0.8% for 10-year yields) led to bond volatility fluctuating between 2% and 5.5%, which is also a ratio of 1:2. How can we explain these differences in the response of bonds to interest rate volatility, and what lessons can we draw from the current situation? 

The answer lies in the impact of duration.

FIG 1. Volatility of 10-year US yields vs volatility of yields for the Bloomberg Barclays Aggregate Index, 2000-2023
The white dot indicates the latest observation





Source: Bloomberg, LOIM Bloomberg, LOIM at November 2023. For illustrative purposes only

 

Blame duration?

The performance of a bond (excluding its carry) is largely governed by its duration and the changes in interest rates. Duration measures the relative sensitivity of a bond's price to changes in interest rates. 

Our more inquisitive readers may be interested in calculating the variance of the product of duration and changes in interest rates. From this calculation, we can derive an approximation of the components that make up the volatility of a bond's returns. Subject to a few simplifying assumptions, the answer can be summarised as: it's the product of duration and interest-rate volatility. In other words, the higher the duration of a bond, the greater the impact of interest-rate volatility on its returns. 

While this idea may seem simplistic to our most informed readers if applied to one bond, it becomes more relevant once transposed onto a bond index. In the space of a decade, the duration of such indices has risen from an average of six to nine years, before easing back to seven years (see figure 3). Not only has interest-rate volatility increased in recent quarters, it has risen while duration remains high – a challenging situation in the world of fixed income.

The obvious question is: what happens next? The graphs in figure 2 show the two main fundamentals of index duration: 

• The level of interest rates: when interest rates fall, bond duration automatically increases 
• The average maturity of issues: very intuitively, the duration of indices is an increasing function of the average maturity of the bonds comprising them 

Over the past decade, the duration of bond indices has increased mechanically as interest rates have fallen, but also as the maturities of issues have lengthened. Since 2021, the bond world has begun to pull back and shorter issues are appearing, while rising yields continue to lighten the duration of indices. As figure 3 shows, the duration of the most closely followed bond indices has fallen by more than a year. So, while interest-rate volatility has indeed reached high levels, a second-order effect – the fall in duration – could have a tempering influence.  

Figure 2: Duration of the Bloomberg Barclays Aggregate Index vs level of rates and maturity (2000 to 2023) &
The red dots indicate the latest observations

Source: LOIM, Bloomberg at November 2023. For illustrative purposes only
 

Fig 3: Duration of BofA Merrill Lynch fixed-income indices



Source: Bloomberg, LOIM at November 2023. For illustrative purposes only.

 

Nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasters currently show:

• Growth slipped with the publication of the US ISM, which fell unexpectedly
• Inflation remained stable, with 55% of data rising in the past week
• Monetary policy surprises are a subdued risk with the Federal Reserve in ‘pause mode’ but marginally more concerned about growth

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

For professional investors only

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