The tradeoff between risk and return is a foundational investing concept. To generate return, investors must be willing to accept risk. Conversely, investors who wish to avoid risk altogether can’t expect to generate a meaningful return.
Today’s bond market offers investors an unusual set of tradeoffs in this regard. Yields on 2- and 10-year treasury bonds are very similar today, meaning investors can generate nearly as much return by owning a 2 year bond (2.6%) as a 10-year bond (2.85%), but with a fraction of the risk.
“Duration” is a unit of risk that measures how much a bond’s price goes up or down in response to interest rate movements. The 2-year treasury has a duration of 1.9, meaning it would fall in price approximately 1.9% in response to a 1% rise in interest rates. By comparison, the 10-year treasury would be expected to fall 8.6% in price if rates were to rise 1%. To us, this means investors have an incentive today to tilt bond portfolios toward shorter term maturities.