Discover the importance of bond duration as interest rates continue to rise in the United States. Read about the definition and how it gauges interest rate risk.
It’s common to talk about the duration of a bond portfolio in simple terms—like time or interest rate sensitivity. But a deeper understanding of duration can be vital these days because the Federal Reserve has increased interest rates significantly, raising its target rate 10 times as of June 2023 in its fight with inflation.
First off, let’s make the distinction between duration versus maturity.
There’s a date a bond is made available in the market (the issue date) and a date it’s expected to be retired (the 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.
So, what’s bond duration, and how is it different from maturity? Duration measures the sensitivity of a fixed income investment to a change in interest rates and is expressed in years. Duration is the amount a bond’s value is calculated to increase or decrease with a 1% change in interest rates.
Unlike maturity, duration takes into account interest payments that occur throughout the life of the bond. Keep in mind, duration tracks all the income streams from a bond or portfolio of bonds. It can be vital to know your overall exposure if you hold a portfolio that includes several bonds, bond mutual funds, or exchange-traded funds. Most actively managed U.S. bond funds can carry about the same interest rate risk as the index they track, according to Morningstar.
Duration is used to measure a bond’s potential price volatility versus 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 a bond’s price typically dropped as interest rates went up.
If an investor expects interest rates to fall during a bond’s lifetime, a longer duration could be appealing because the bond’s price may increase more than comparable bonds with shorter durations. On the other hand, if an investor expects interest rates to rise during a bond’s lifetime, a shorter duration may be more appealing because it’s less exposed to fluctuations in interest rates.
A little math is often the best way to describe duration. And don’t worry; there’s no bond duration formula you need to memorize. 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 five years, a 1% increase in interest rates would cause the bond to decrease 5% in value. Conversely, a 1% decrease in interest rates would cause the bond’s value to increase 5%.
The duration on any bond that pays coupons will be less than the maturity because some of the payments are yet to come before the maturity date. A zero-coupon bond (a bond paying no interest) will have a duration equal to its term. And bonds with higher current yields tend to have lower durations than bonds with lower current yields.
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 rate, 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. Let’s look at an example.
Suppose you bought a $1,000 par value bond with a 10-year maturity and a 2% coupon rate. You can earn 2% of $1,000, or $20, each year 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 3% coupons. Investors can choose between your 2% bond and a new 3% bond. To entice someone to buy your bond, you’ll have to discount its price so the new owner will earn the same $20 but will have paid less than $1,000 to buy it, thus raising the yield closer to 3%.
Using the same example, suppose when you sell your bond, new bonds are being issued with 1% coupons. Investors can choose between your 2% bond and a new 1% bond. Comparatively, your bond is now much more attractive. An investor is likely to be willing to pay more than $1,000 to earn 2% rather than 1%.
The Federal Reserve began raising rates in March of 2022 as it initiated its efforts to try to rein in inflation and bring it back to its historical target inflation rate of 2%. The Fed subsequently hiked rates in 10 consecutive Federal Open Market Committee (FOMC) sessions, bringing the federal funds target rate to 5.00% – 5.25% as of June 2023. Consequently, the average 10-year Treasury yield has spiked from around 1.5% in January 2022 to highs just above 4.3% by October, before settling back to a range near 3.8% by late June 2023.
Importantly, monetary policy changes impact the front end of the yield curve, and growth drives the long end of the curve. The longer end has generally been moving up over time as the U.S. economy continues to expand and jobs remain abundant, while unemployment is near historical lows. As with 10-year Treasuries, the 30-year bond yield rose to around 3.8% as of midyear 2023. However, the compounding federal funds rate hikes have contributed to an acceleration of yields on 2-year Treasuries, which have risen to around 4.7% as of June 2023. This is beyond the rates offered on longer-term bonds, which creates an unusual yield scenario known as an “inverted yield curve.” Historically, this scenario has signaled the potential for a recession within the next year or two.
Clearly, investors should periodically evaluate their fixed income holdings to determine if they’re being amply compensated for the duration risk of their holdings and that they’re well positioned for the prevailing interest rate environment. This can be especially important for investors who are seeking income.
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