The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

DURATION AND YIELD CURVE

The very extreme case of two assets, cash and 30-year U.S. Treasury bonds, provides an example of the clean, unambiguous importance of duration. Over the short term in this portfolio, the vast majority of return performance is determined by the change in long U.S. Treasury rates and the percentage of the portfolio allocated to the long U.S. Treasury. Ambiguities regarding investment intent increase with the number of permissible investment choices. For example, merely adding a zero-coupon bond whose duration is similar to that of the long U.S. Treasury bond complicates the decision process. The zero-coupon bond, although similar in duration to the 30-year U.S. Treasury, has a unique set of performance characteristics. Its dynamic yield curve and volatility changes as well as duration decay will differ over time from the 30-year U.S. Treasury. Although possible, it is unlikely for a crosscurrent of portfolio themes to prevail in this example.

As investment alternatives expand, the crosscurrents of decision making increase at a substantially greater rate. In Exhibit 20.6, the ambiguities of these choices and their impacts are noted by the double arrows indicating feedback effects. The exhibit attempts to include all of the possible investment choices available to the fixed income portfolio manager and to illustrate the volume of decisions that are constantly required to manage an international portfolio.

Forward curves (future yield curves predicted ...