Investors adding bonds to a stock-heavy lineup may opt for securities with a shelf-life designed for today’s investing climate. That’s where duration comes in.
It’s not inaccurate to talk about the duration of your bond portfolio in simple terms—like time, or interest-rate sensitivity. However, a deeper understanding of duration can be vital these days as interest rates have been increasing from their record lows a few years back.
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 (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 and is expressed in years. In plain speak, 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 or 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 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 could be appealing; thinking 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 since it is less exposed to fluctuations in interest rates.
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 years, a 1% increase in interest rates would cause the bond to decrease in value 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 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. 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, 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 is likely to be willing to pay more than $1,000 to earn 6% rather than 5%.
The Fed has raised the Fed Funds rate 6 times since December 2015 and the markets are expecting as many as an additional two increases by year end. The yield on the 10-year Treasury now stands at 2.88%, up almost 60 basis points (bps) from when the Fed began to tighten monetary policy. Compare that to the yield on the 2-year Treasury which is up by 150 bps.
This is because monetary policy changes impact the front end of the yield curve and growth drives the long end of the curve. Investors should not look at the increase in rates on the long end over the last 2.5 years as the gauge of what might be expected in the coming months and years.
Investors should periodically evaluate their fixed income holdings to determine if they are being amply compensated for the duration risk of their holdings and that they are well positioned for a rising rate environment. This can be doubly important for investors seeking income.
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