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Bond Duration: Not Just Passing Time. What You Need to Know

February 5, 2013
Tight Rope

Bond duration is one of those terms most investors think they understand. That is, until they actually have to define it. We’ll help.

It’s not inaccurate to talk about the duration of your bond portfolio in simple terms—like time, or interest-rate sensitivity. You can do better, however. A deeper understanding of duration is vital these days. Market analysts don’t know precisely when change is coming, but ultra-low interest rates are seen as increasingly unsustainable, even if the global economy improves at a slow rate.

It’s because of this uncertain interest-rate outlook that you may have to rethink the make-up of the income-generating holdings tucked nicely into your portfolio. And those investors looking to add a bond accompaniment to a stock-heavy lineup may opt for securities with a shelf-life specifically designed for today’s investing climate. That’s where duration comes in—how long, or short, should I go?

The answer to that question hinges on a variety of factors exclusive to each investor and is best addressed by your fixed-income professional. But before your strategy sit-down, let’s tackle some bond lingo so that you enter this next market stage prepared.

Off the top, it’s important to make the distinction between duration and maturity.

There’s a date a bond is made available in the market (issue date) and a date it’s expected to be retired (maturity date). Maturity refers to the length of time a bond is expected to be outstanding. There are several factors that can affect a bond’s maturity, but at maturity, the principal amount of a bond or note is repaid to the investor and interest payments cease.

Duration, however, measures the sensitivity of a fixed-income investment to a change in interest rates. In plain speak, duration is the amount a bond’s value will increase or decrease with changes in interest rates. Unlike maturity, duration takes into account interest payments that occur throughout the life of the bond. Keep in mind that duration tracks all the income streams from a bond or portfolio of bonds. It’s vital to know your overall exposure if you hold a portfolio that includes several bonds or bond mutual funds or exchange-traded funds. According to Morningstar, most actively managed U.S. bond funds can carry about the same interest-rate risk as the index they track.

It’s fair to say that investors use duration to measure a bond’s potential price volatility to changes in interest rates. Historically, the higher the duration (the longer an investor needs to wait for the bulk of their inter­est payments), the more its price typically dropped as interest rates went up. If an investor expects interest rates to fall during a bond’s lifetime, a longer duration may be appealing; thinking the bond’s price may increase more than comparable bonds with shorter durations.

Word Problem

A little math is often the best way to describe duration. So here goes. Duration is the change in the value of your fixed-income security that might result from a 1% change in interest rates. For example, for a bond with a duration of 5, a 1% increase in interest rates would cause the bond to decrease in value 5%. Equally, a 1% decrease in interest rates would cause the bond’s value to increase by 5%.

The duration on any bond that pays coupons will be less than the maturity because there is some amount of the payments that are going to come before the maturity date. A zero coupon bond (a bond paying no interest) will have a duration equal to its term. Last, bonds with higher current yields tend to have lower durations than bonds with lower current yields.

Price Impact

In simple terms, a bond’s duration is one method used to determine how its price may be affected by interest rate changes. In fact, the bond’s duration, coupon, and yield-to-maturity, as well as the extent of the change in interest rates, are all significant variables that ultimately determine how much a bond’s price moves.

Suppose you bought a $1,000 par value bond with a 10-year maturity and a 6% coupon rate. You can earn 6% of $1,000, or $60, each year that you own the bond. Let’s further assume that after one year, you decide to sell it, and at that time, new bonds are being issued with 7% coupons. Investors can choose between your 6% bond and a new 7% bond. To entice someone to buy your bond, you will to have to discount its price so that the new owner will earn the same $60 but will have paid less than $1,000 to buy it, thus raising his or her yield closer to 7%.

Using the example above, let’s assume that when you sell your bond, new bonds are being issued with 5% coupons. Investors can choose between your 6% bond and a new 5% bond. Comparatively, your bond is now much more attractive. An investor will be willing to pay more than $1,000 to earn 6% rather than 5%.

Why Now?

Currently, a 10-year Treasury note interest rate is near 1.95%, about half of where it stood five years ago. Even mild changes in interest rates can be felt in a bond market that has clocked a 30-year bull run.

Rates will not stay at these levels forever. Investors should periodically evaluate their fixed income holdings to ensure they are being amply compensated for the duration risk of their holdings and that they are well positioned when interest rates finally do rise. This is doubly important for investors seeking income.

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