Fixed income yes, but for what duration?

Fixed income yes, but for what duration?

Communications

Bonds, T-bills, and commercial paper are fixed-income assets. Their duration, which can range from a few months to decades, is important for judging their suitability. A few tips for improving your strategy are provided here.

For a few months now, individual savers have been somewhat euphoric for T-bills, after years of being anything but attractive. What’s happened is that the rise in interest rates has hastened the return of profitability to fixed income, a type of investment usually preferred by more conservative customers who are interested in a lower level of risk than what is generally presented by equity income. 

Yet the name fixed income hides some very different classes of assets. Beginning with whether or not the issuer is a public entity or a private company and followed by the term for which they are issued, or their duration. 

In fact, that duration is used as a thermometer of the volatility of a fixed-income security, given that the longer the term, the greater the price fluctuations of the security due to changes in interest rates. Thus, a short-duration bond (less than 3 years) is usually less affected by interest rate increases, and therefore considered a less risky asset than another type of security with a longer duration. 

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Short- and long-term assets

Within fixed income, there are securities with durations that range from just a few months to up to decades. Let’s look at the main types.

  • Public Debt
    • T-bills: between 3 and 18 months.
    • Government Bonds: beginning at 3 years and no more than 5 years.
    • Government Debentures: beginning at 5 years and even up to 50 years.  
  • Private fixed income
    • Commercial paper: the maturity is short term, and the most frequent issuances are 1, 3, 6, 12, and up to 18 months. 
    • Simple bonds and debentures: they are medium- and long-term securities, meaning 2 to 30 years.

Different strategies

Currently, interest rates range between 4% and over 5% in the Euro area and the USA. These rates are occurring at a time when central banks are debating whether to continue increasing interest rates in order to curb inflation or change their monetary policy in an attempt to contain the deterioration of economies. In other words, we don’t know if the maximums have already been reached, if rates will remain at the current levels for a certain period of time, or if they will soon begin to drop, not to mention how the economy will be affected. All these questions are important for judging the suitability of a type of debt that has a longer or shorter duration.

Nevertheless, the majority of experts today agree that the remuneration from short-term fixed income assets is attractive, for which the duration has not increased much and therefore neither has the risk. To the extent that interest rates drop, then extending the term and increased risk will have to be weighed against the greater possibilities of ensuring a return.

Furthermore, trying to anticipate interest rate movements is what professionals do when managing the risk in an investment portfolio. Within an environment of rising interest rates, they seek to reduce the duration of assets as much as possible in order to try to minimize the impact of new rate increases.  And, conversely, if they expect interest rates to fall, they increase the duration of the portfolio in order to benefit as much as possible from rate cuts.