As financial advisors prepare for the Federal Reserve (the "Fed") to begin raising interest rates for the first time since 2006, it may be a prudent time to consider shortening the duration of their clients' fixed-income portfolios.1 Considering the relatively low yields offered by long-term bonds, an interest rate increase of 1 or 2 percentage points could result in a price decline equivalent to multiple years of income. For example, as of 8/31/15, the yield-to- maturity for the Barclays US Aggregate Bond Index was 2.4%, with a modified duration of 5.6 years.2 This implies that for every 1% increase in interest rates, the price of the index could decline by roughly 5.6%.
The difficulty with shortening duration, however, is that short-term yields for investment grade bonds are currently too low to meet the income needs of many investors. As a result, financial advisors must determine whether lessening interest rate risk while accepting more credit risk is a worthwhile tradeoff, in order to attain a more desirable level of income. For example, while the First Trust Senior Loan Fund (FTSL) bears more credit risk than the Barclays US Aggregate Bond Index by investing in a portfolio of below-investment grade floating-rate senior bank loans, the fund has minimal interest rate risk with a weighted average effective duration of 0.84 years, while offering a 30-Day SEC Yield of 4.06%.3,4
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1 Duration/Interest rate risk is a measure of a security's sensitivity to interest rate changes that reflects the change in a security's price given a change in yield.
2 Yield-to-maturity is the total return anticipated on a bond if the bond is held until the end of its lifetime.
3 As of 8/31/15. Weighted average effective duration is a measure of a bond's sensitivity to interest rate changes that reflects the change in a bond's price given a change in yield. Given that senior loans typically pay a floating rate of interest, they tend to have an effective duration of almost zero. As such, we estimate the duration for senior loans to be approximately 0.25 years.
4 As of 8/31/15. The 30-day SEC yield is calculated by dividing the net investment income per share earned during the most recent 30-day period by the maximum offering price per share on the last day of the period and includes the effects of fee waivers and expense reimbursements.