Less Risk for Strong Returns in Bond Portfolios

Abstract

Bond portfolio managers obviously need good measures of the risk of their portfolios. The level of yields affects the variance of bond returns in a complex way because duration decreases (increases) as yields rise (fall). On the other hand, the volatility of yields frequently increases (decreases) as yields rise (fall). An additional complicating factor, especially important for longer maturities, is the negative relation of convexity to the level of yields. We show variance may increase or decrease with level of yield depending on the model used, bond maturity, and time varying conditional variance of yields. It is noteworthy that second order relationships can give rise to results that are dramatically different from first order. It is very useful and appealing that shorter maturity bond risk may decline with lower levels of yield and strong returns.