Pension investors are overthinking duration risk: FTSE Russell

New research from FTSE Russell suggests pension investors may be overthinking duration risk and undervaluing what's hiding in plain sight - the yield they lock in at the point of purchase.

The paper - the third in a series from the index provider's global investment research team - examined US Treasury returns from 2000 to 2026 across short, medium, and long-dated maturity buckets. Its core conclusion was that starting yield levels on sovereign bonds are a reliable predictor of future returns, and the relationship strengthens when an investor's holding period matches the maturity of the bond index.

According to FTSE Russell’s Indrani De, the team studied US Treasury returns from 2000 to 2026, a window De considers the modern era given the creation of the Eurozone and the macro regime shifts that followed - from pre-GFC high yields to the post-crisis collapse in rates and the normalization that came after.

Why yield valuation matters for bond investors

“It's a world we can correlate to, but a long time series where we can have confidence in the results. And the net result is simply that valuation matters. Even in the risk-free sovereign bonds, lower valuations mean potentially higher returns,” explained De, head of global investment research at FTSE Russell. “Yield levels today are fairly high, meaning valuations are low. So we have the benefit of sovereign bonds being reasonably valued today. It's also interesting that the strongest correlation between the starting price level and future returns happens when the investment horizon matches the maturity of the bond index.”

Robin Marshall, director of global investment research at FTSE Russell, broke the returns into three components: carry (the coupon), roll down (the price appreciation a bond picks up as it shortens along an upward-sloping curve), and duration-driven price effects from yield movements. Of those three, carry and roll down dominated across most time horizons and maturity buckets, he said.

"What we found over that period from 2000 to 2026 is so called mean reversion of yields, that yields basically average out over that period. So, over the longer investment horizons, particularly, the durational price effects tend to wash out," he said. "But what you've got in the background that goes on driving your returns are the coupon and the roll down the curve."

Don’t get caught up in duration risk: Marshall

That finding carries a pointed implication for institutional investors who fixate on interest rate direction as Marshall argued that too many investors get caught up in duration risk, worrying about whether they have too much or too little exposure to rate movements when the data points to carry and roll down as the more consequential drivers of return.

The relationship between those components will shift depending on the maturity of the bond and the holding period in question, but over medium and longer horizons, the research found carry and roll down were the forces that mattered most.

"If you've bought a bond that's currently yielding 4 or 5 per cent in those upper quintiles as we describe them, then you've got a pretty good chance of a decent return of 5 per cent or more if the price effects, the duration or the price effects wash out," added Marshall.

De agreed, framing it in terms pension allocators will recognize.

"For a layman fixed investor, it's more that the starting level of the yields, that level is more important in most cases than the delta, the change in rates in whichever direction," she noted.

What starting yields tell bond investors about future returns

The team analyzed the three main FTSE Russell Treasury indexes — one to three year, seven to 10 year, and 20 years plus — and sorted historical starting yields into quintiles. The fifth quintile represents the cheapest valuations – or highest yields.

According to Marshall, a single bond held to redemption would guarantee its starting yield at maturity, which would rig the result. Meanwhile, constant maturity indexes continuously rotate bonds in and out as they age, meaning the composition shifts over time and the analysis needs to earn its conclusions.

The results ultimately confirmed what the team expected: the predictive power of starting yields peaked when the investor's holding period matched the maturity of the index. Short-dated bonds showed the strongest correlation at a two-year horizon. The seven-to-ten-year index peaked around the seven-to-ten-year mark while the same pattern held for the long end.

Where the holding period and maturity diverged, the correlation weakened — and in the case of long-dated bonds held over short horizons, duration effects could overpower carry and roll down, particularly if an investor entered at rock-bottom yields like those seen during COVID

As to where current valuations stand, “they are very cheap given its long-term history, which given the research bodes well for the kind of returns one can expect from them,” said De.

For multi-asset pension investors, she argued the comparison with equities sharpens the picture.

"If your seven-to-ten-year yields are about four and a half, 4.6 per cent, think of what an investor is looking for, particularly if it's a strategic asset allocation period. What are you expected to get from equities over the long run? Equities are very expensive," she said, underscoring risk assets are expensive, and sovereign bonds are cheap by their own historical standards.

Where sovereign bonds sit in the broader asset picture

According to De, valuation as a framework is standard practice in equities and credit. But in sovereign bonds, she suggests the conversation happens far less often. The team wanted to test whether the same relationship between starting valuations and future returns held in the risk-free space.

The results confirmed that it does, along with the message that bonds serve as the risk-free rate for every country's broader asset universe, with US Treasuries sitting at the foundation of the entire global financial system.

Marshall agreed, adding that over the past decade, credit spreads have tightened considerably as high yield has now become expensive on a relative basis, and investment grade has followed the same path. Meanwhile, government bonds, have been left behind.

Marshall suggests that ultimately leaves Treasuries and TIPS as the cheapest asset classes in US fixed income on a relative value basis over the past 10 years. Because the curve has been steepening, the long end is the cheapest segment within the maturity buckets as well.

"When you look at those sorts of yields, if you're looking out over that longer time horizon, you would say these are now quite attractive on a relative value basis both within the fixed income and against these other risk assets," he said.