Morningstar - Q1 2020 - 44

Strategies

The Sharpe Choice
Long-duration bonds diversify
equity-heavy portfolios.

RESEARCH: DURATION

Megan Pacholok and Jason Kephart

The yield on the 30-year U.S. Treasury fell
below 2% for the first time ever on Aug. 15 and has
changed little since. That marked an incredible
rally in those bonds, which were yielding
nearly 3.5% on Nov. 2, 2018. Vanguard Long-Term
Treasury ETF VGLT, which mainly holds U.S.
government bonds with maturities between
20 and 30 years, rallied 31.9% over that
time period, nearly triple the 11.9% return of
Vanguard Total Bond Market ETF BND.
Clearly, long duration has been on a hot streak,
so it may seem like a poor time to jump in.
For investors with big equity allocations, however,
long duration is one of the best diversifiers
for a portfolio.

was 4.5 years. That increased sensitivity makes
long-duration bonds a particularly volatile asset
class, and on a stand-alone basis, it certainly
doesn't look like a very attractive asset class when
looking at its Sharpe ratio, which is a measure
of its risk-adjusted return.

A Quick Refresher on Duration
Duration is a measure of sensitivity to interest
rates: the higher a fund's duration, the
more sensitive it will be to moves in interest
rates. For example, a bond fund with a duration
of 5.0 years would be expected to gain
(or lose) 5% of principal for a 1% parallel fall
(or rise) in interest rates across the yield
curve. Things can get more complicated depending
on exactly where on the yield curve the
fund is most concentrated, but the general
idea holds.

Long-duration bond funds are subject to a lot
of interest-rate risk. The average effective
duration for the long-term government Morningstar
Category was 17.6 years at the end of October.
For comparison, the average effective duration of
the intermediate-term government category

EXHIBIT 1

Duration Boost The worse stocks perform, the better long duration does.
Duration Performance Compared With the S&P 500

Long

Intermediate

Short

Average Return

2.0
1.5

1.36

1.0

0.72

0.72
0.37

0.48

0.29

0.38

0.27

-0.05

0.33

0.31

0.5
0
-0.5

-5% to 0%
Less than -5%
Vanguard 500 Index Monthly Return

0% to 5%

Data from November 1991 through October 2019. Source: Morningstar Direct.

44

Vanguard Treasury Funds
Annlzd
RTN
(%)

Max
DrawStd Sharpe down
Dev Ratio
(%)

Short-Term Treasury VFISX 3.88 1.95 0.69 -2.23
Interm-Term Treasury VFITX 5.55 4.73 0.64 -6.47
Long-Term Treasury VUSTX 7.52 10.02 0.52 -16.68
Data from November 1991 through October 2019.
Source: Morningstar Direct.

Even though the long-term Treasury fund had
the highest annualized return, its higher
returns didn't compensate for its higher volatility,
which results in the worst Sharpe ratio
of the three. The long-term fund also had by far
the worst max drawdown of the three over
the period, so again, on a stand-alone basis, it's
not necessarily what one would think is
a great diversifier.

2.5

2.47

Long

Below are the annualized return, standard
deviation, and Sharpe ratio for long-term,
intermediate-term, and short-term U.S. Treasury
bonds, using Vanguard's suite of Treasury
funds as proxies, from their common inception in
November 1991 through Oct. 31, 2019. The
Treasury funds are free from credit risk, unless
there's the unlikely event the U.S. government
defaults, so using Treasury funds isolates
the duration risk.

Other

Morningstar Q1 2020

% of Bond Allocation
100

Greater than 5%

When Duration Helps
Interest rates and equity prices have historically
had an inverse relationship. As economic
risks make stocks in aggregate less attractive,
investors look to the safety of fixed income-
particularly U.S. Treasuries, which carry
virtually zero risk of default, as noted previously.
Over the past nearly 30 years, the greater
the worry about stocks, the better duration
has done. EXHIB IT 1 shows the average
return for each of the three Vanguard Treasury
funds depending on the monthly return of
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