Talking Shop: Risks of Extending Duration in Investment Policy

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Member question: “I’d appreciate your insights and experience on the following questions regarding changes in investment policy:

1. “If we extend the duration and/or the maximum maturity of a single instrument, is there any statistic, research report, etc. which could help illustrate the level of increased risk associated with longer tenors?
2. “Overall, how do you decide what duration or maximum maturity is the most appropriate?”

Peer answer 1:  “Regarding 1., extending duration/maturity essentially reduces liquidity, and liquidity in this case is defined as the level of realized gain/loss from a liquidation or forced sale of a security. Thus, you will need to compare the volatility of the (unrealized) gain/loss position in a portfolio resulting from adding longer duration securities.

• For 2., you can look at the above analysis and compare it to your comfort level. You can also point to common practice. In a typical segmentation, my guess is that medium-term would be a maximum three-year maturity with a portfolio duration of 1.5 years; and longer-term would be a maximum five-year maturity with a max portfolio duration of 2.5 years.”

Peer answer 2: “On the second question, we typically try to avoid having to sell things prior to maturity to avoid bid-ask spread or fees charged by banks in case of term deposits.

• “So with that in mind, we set the maturity for the instrument based on how far out we are comfortable holding it, as we assume we will have it to maturity. With the exception being longer dated bonds, as we may sell those based on other reasons.
• “For the first point, one additional risk to consider when going longer is that you will increase your duration risk, so changes in rates will have a greater impact on mark-to-market values. Also, if rates rise (fall), you will be locked into a lower (higher) rate longer.”