Blue Elephant Capital Management

One of Finance’s Seven Dirty Words?

“There are some people who would have you not use certain words. Yeah, there are
400,000 words in the English language, and there are seven of them that you can’t
say on television. What a ratio that is. 399,993 to seven. They must really be bad.
They’d have to be outrageous, to be separated from a group that large. All of you
over here, you seven. Bad words. That’s what they told us they were, remember?
‘That’s a bad word.’ ‘Awwww.’ There are no bad words. Bad thoughts. Bad
Intentions.”

  – George Carlin, from “Seven dirty words you can never say on television”

I was on a panel recently discussing investment strategy in our marketplace lending
fund. On the panel were three other managers with different philosophies around
building loan portfolios. There was one striking similarity between us – we all used
the word “duration” like it was one of the words from George Carlin’s famous “seven
dirty words” sketch – a curse, said only in whispers, never to be used in polite
company. This parallel to the “seven dirty words” routine got me thinking– is
duration always a bad word? What is “duration” anyway?

Investopedia defines duration as “a measure of the sensitivity of the price (the value
of principal) of a fixed income investment to a change in interest rates. Duration is
expressed as a number of years. Rising interest rates mean falling bond prices, while
declining interest rates mean rising bond prices.” To translate this into English, let’s
use a real example. The US Treasury recently issued a ten-year maturity bond that
pays a coupon of 2.125%. This bond had a duration of around 8 years and a price
right around par, or $100, when issued. The duration of 8 years tells us that if that
bond’s yield were to move in yield terms from 2.125% to 1.125% (lower by 1%), the
price of that bond would appreciate by approximately 8%, moving from $100 to
$108 (this ignores the impact of convexity, which we’ll save for another time). Of
course, a move to 3.125% would equate to $92, a loss of 8% of principal.
A quick look at the last two decades of ten-year treasury yields suggests that
duration shouldn’t be a dirty word at all. Investors in fixed-income have been

tenyeartreasury

handsomely rewarded for taking duration risk – if anything, duration has been a
blessing, not a curse.

Why, then, does duration carry such a negative connotation? I’d argue that the
negative feelings on duration come from fear that the downward trend in interest
rates will stop and then reverse, a fear that is completely rational for those lending
money in traditional fixed income markets for ten-years near 2%. Does this risk
have the same implications for our loan portfolio?

To answer this question, we need to consider another fact about fixed income. When
we invest a loan or a bond, we are the lender. Often overlooked is that on the other
side there is a borrower. Whether this entity is a person, corporation or
government, the loan must be paid back on or by the date set out in the contract for
the bond to retain its value. This is where duration takes on a more complex
meaning. If duration was truly harmful, all bond issuance would take place in
overnight markets, where there would be no duration risk at all. This would
introduce an entirely different type of risk to the equation – refinancing risk.

Let’s consider lending money to a fictional company called Initech, a small business
that has been around for ten years and consistently runs a profit. Initech sees an
opportunity to start a new business and needs to borrow $100,000 for five years. I
offer them a five-year loan at 18%, while another lender offers them a six-month
cash advance at 25%. Which loan is riskier? The loan rates are so much higher than
US Treasury rates that there is very little traditional duration risk to either loan,
though I’d admit the duration of the five-year loan is higher. However, the six-month
loan is infinitely riskier. It is highly unlikely that Initech can make good on their new
business in just six months at such a high interest rate. If there is any short-term
stress either in the loan markets or in their business, they are likely to have funding
problems and default. This is exactly what happened to corporations in 2008 – they
were funding short term but had long-term liabilities. Since the five-year loan
matches their funding needs, the business has time to grow and generate the
revenue necessary to pay back the loan.

The Initech example highlights that refinancing risk has a significant impact on a
borrower’s likelihood to default. That the short duration loan is riskier is actually
highlighted by the fact that it carries a higher yield than the five year option. Any
borrower that could pass underwriting scrutiny would take the longer duration loan
because it matches their liability profile and has a lower cost. The lender benefits
from the duration, since the borrower is more likely to be able to repay the loan on
time.

At Blue Elephant, our average coupons are between 12% and 19%, depending on
the underwriter, but we do zero short-term funding. Our loans mature over three to
five years and have very little sensitivity to long-term US Treasury rates. This is the
way to maximize the benefits of duration without introducing significant funding
risk. Short-term funders cannot outrun a default cycle, no matter how high the
interest rate charged.

Now we know the real reason “duration” didn’t make George Carlin’s “Seven dirty
words” routine. Unlike the words on his list, duration, when used by investors that
understand the concept correctly, can be an extremely powerful tool for creating
alpha.