Rick Welch: Dollars and Sense

"What is Bond Duration?"

As defined, bond duration “is the sensitivity of a bond’s price to changes in interest rates.”   Many investors confuse maturity with duration.  In fact, maturity is just one factor that must be taken into account when considering bond duration.  Other factors include bond yield, coupon rate and any call features written into the bond.  Like maturity, duration is also expressed in years. 

The owner of a bond is entitled to a series of cash flows.  For coupon bonds, the cash flows start with the payment of the semiannual coupon for each remaining year of the bond’s term or up to an earlier call date.  Coincident with the final coupon payment is the return of the face value of the bond. In the case of coupon bonds, duration is always less than maturity.  To calculate duration, one must determine the time-weighted value of the cash flows and divide that figure by the current price of the bond. Considered in this context of cash flows, duration could also be defined “as the length of time before an asset is due to be repaid.”  I like to think of bond duration in more simple terms, as in when I get my money back.    

Earlier this year, we saw the rate on the benchmark ten (10) year US Treasury rise quickly from 1.56% to 2.98%.  As interest rates rise, the prices of fixed income securities, like bonds, fall.  Many investors look to the 1% rule which suggests that for every movement of 1% in interest rates, bond prices will change (in the opposite direction) in an amount roughly equal to their duration. For example, the price of a bond with a five (5) year duration will fall by about 5%, if interest rates rise by 1%.  It is important to note, however, that bond yields do not change uniformly across the yield curve in times of changing interest rates.

Duration then provides an easy way to compare bonds or to evaluate a portfolio of bonds.  Bonds with a longer time to maturity will have higher duration, which in periods of rising interest rates, can translate into higher interest rate risk.  A higher coupon bond will have lower duration than one with a lower coupon rate because the cash flows from the higher interest payments means the face value of the bond is repaid sooner.    

Low or moderate duration strategies are appropriate in bond bear markets when we expect interest rates to rise. During 2013, we have recommended a “low to the ground” approach for bond portfolio duration with a target duration of under 5 years.  With this approach we have reduced some intermediate and long term bond positions, particularly in US Treasuries.  Some alternative fixed income strategies like convertible bonds and floating rate bank loans may be appropriate for some investors.  Adding a mutual fund in the high yield category is another way to lower overall portfolio duration.  In general, during periods of rising interest rates, active management of fixed income assets is preferred over passive.

Let’s test your understanding of duration.  With a zero coupon bond, is duration less than, greater than or equal to maturity?  The correct answer is that with a zero coupon bond, duration is equal to maturity as the only cash flow from the bond is the one time payment of principal and interest upon maturity.

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