In today’s investing climate, having a deeper understanding of bond duration can be vital as interest rates have declined significantly.
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 as interest rates have declined significantly, effectively down to zero for the federal funds rate in the wake of the COVID-19 pandemic.
First off, it’s important to make the distinction between duration and 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 that 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 in value by 5%. Conversely, 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 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.
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 lowering rates in late 2019 and turned the dial all the way down to effectively zero in March 2020 when the coronavirus pandemic hit. The yield on the 10-year Treasury fell to an all-time low near 0.5% in August 2020 before roaring back in early 2021 to about 1.6%. That’s still historically low, however. The yield on the 2-year Treasury stood below 0.2% approaching mid-year 2021, also historically weak.
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 emerges from the pandemic and more people get vaccinated. The 30-year bond yield rose to around 2.3% by mid-year 2021 versus all-time lows below 1.2% in mid-2020. A 2.3% yield is still historically low for the 30-year but certainly would seem to signal more enthusiasm about U.S. future growth than we saw during the height of COVID-19.
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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