Are you a bond or bond fund investor or manager? Are you sure your bonds are best in the current low interest rate environment and would stand to benefit in the foreseeable interest rate rise? Interest rates have always been the key risk driver for the returns you get from your bonds. Interest rates affect bond prices inversely, that is, a rise in interest rates indicates a fall in bond prices and vice versa.
As interest rates increase, issuers must pay higher yields to issue new bonds, and the value of previously purchased fixed rate bonds falls. This increases sensitivity of bond prices to interest rate fluctuations. Duration is a measure of this sensitivity. By knowing the duration of the bonds in your portfolio, you are in a position to predict price movements in your bonds, provided you have a clear idea of interest rate movements in the foreseeable future.
In its simplest form, duration is the time taken, in years, by a bond’s internal cash flows to recover its cost. Bonds with low duration bear less interest rate risk, as their cost is recovered faster so the price of the bond is less susceptible to interest rate changes. The higher the duration, the more the bond’s price will react to interest rate changes. So, it is a measure of the sensitivity of a bond’s price to changes in interest rates.
All else equal, bonds with high coupon rates and high yields will have low duration as the cost is recovered faster. Similarly, bonds with longer maturities will have higher duration. A zero coupon bond has its duration equal to maturity, as there are no intermediate cash flows that recover its cost.
In the current low interest rate environment, bonds will tend to have higher downside risk in terms of interest rate risk. Hence, bonds with shorter maturities will be the ones with lower duration, that is, a lower interest rate risk in the future. As interest rates rise in the future, bond prices will tend to fall, hence, holders of bonds with longer maturities will tend to lose vis-a-vis those holding shorter maturity instruments.
Continue learning about the factors impacting the value of your bond portfolio through How bond prices, interest rates, and credit spreads correlate.
© 2013 Market Realist, Inc.