Hidden Duration: Interest Rate Derivatives in Fixed Income Funds

Abstract

Fixed income funds carry significant duration risk from their use of interest rate derivatives (IRDs). This duration risk is hidden, as funds typically disclose portfolio duration weighted by market values instead of notionals, concealing their true risk. We find substantial variation in IRD duration, both across funds and over time. The primary motives behind funds' use of IRDs are not to hedge interest rate risk or manage flow risk; rather, they are driven by risk-taking and extending duration risk exposure. During our sample period from 2019 to 2023, returns on funds' IRD positions were the major driver of their performance, overshadowing returns on their non-IRD positions. The performance of funds' IRD positions is not associated with manager skill-funds that outperformed due to high IRD duration in early 2020 performed particularly poorly during interest rate hikes in 2022 and 2023.

Keywords: Derivatives, Interest Rates, Fixed Income Funds, Leverage, Duration

JEL Classification: G11, G12, G23