What is negative duration when talking about bonds, and why can that be a good thing?
In a fantastic year of rallying asset classes, there's always going to be a negative standout. In 2019, International Bonds was that negative standout. We must remember that though hindsight is 20/20, foresight is not. The challenge when dealing with the problem is that typically last year's laggard holding is next year's top performer, or close to it. You step off the tracks and you run the risk of getting mowed down by a train coming in the other direction. Before we get into the perfect storm that was 2019, let's talk about negative duration briefly. Many of you know from previous videos that duration is inversely related to interest rates. That means in English, when interest rates go up X percent, the value of the bond falls Y percent and vice versa.
Interest rates fall, bonds go up and most bonds have seen that. Often for diversification purposes, we'll get a portfolio of bonds that have negative duration so that when the bulk of the portfolio loses value, those remaining bonds will gain in value. You can see the diversification value in negative duration. Bonds that had negative duration were international this year - someone had a perfect storm. With interest rates down, they lost value. With Argentina hammered in August, all international bond funds got hurt. Negative duration was not our friend this one time. Interest rates down around the world led to a strengthening of the dollar, which is a little bit unusual.
This perfect storm hit managed international funds particularly hard in 2019. Something gets hit every year. But most of these items - those seesaw items - they’re zero sum items, which means they will return. Interest rates will go up at some point. The dollar will weaken at some point. When that swing occurs, there'll be significant positive outcome for the very same holdings. This is great for diversification, but it does result in tracking error.
Tracking error is when a holding does not follow the index that's associated with it. Some clients can't stand tracking error. To sleep better, we recommend those clients go ahead and lose a little bit of the diversification value and alpha that comes from those managed bond funds and stick to international indexes. A great example of this would be Templeton. Templeton put on some wonderful long-term funds versus the international bond index, especially if that index has hedged.
Templeton got hammered in August, but if you map the index over three, five, 10 to 15 years, Templeton is so far beyond the index over time that it's a very solid holding. Every client is different. Those who can't stand the tracking error should not be in that kitchen, they should be in the index and that's not a bad thing. It's “know thyself” as an investor. Every single year an asset allocation will have an errant asset class. This year, in general even, it was international bonds. Remember this and the long-term, the winners, the survivors, buy low and sell high. As 2019 comes to close, we'd like to wish you a very Merry Christmas and thank you for your confidence and trust in Efficient Wealth Management.