Duration measures a portfolio’s sensitivity to parallel shifts in the yield curve. However, parallel shifts in the yield curve—when interest rates for all maturities across the bond spectrum increase or decrease by the same amount—rarely, if ever, occur.
The current monetary environment presents an example. While short-term Treasury bill rates have undergone little change, long-term (TLT) and medium-term Treasuries (IEI) have experienced greater changes in yields. This is because the Fed has indicated that it will keep the Fed funds rate in the range 0% to 0.25% in order to stimulate employment and bring inflation to its long-term target of 2%. The Fed funds rate has been in this range since December 2008 and is expected to maintained these levels until at least Q2 2015.
However, the longer-term yields haven’t remained constant. Yields on the 30-year Treasury bond (TLT) had increased by 66 basis points between December 1, 2008, and December 17, 2013 (before the announcement of the Fed taper), compared to a decline of 7 basis points in the yields for one-month T-bills (BIL). For this reason, the Fed’s tapering of monthly bond purchases (at $55 billion per month currently) is also expected to impact long-term Treasuries (TLH) and medium-term Treasuries (IEF) more than short-term Treasuries.
To measure the change in portfolio value resulting from non-parallel shifts in the yield curve or twists, investors apply measures such as key rate duration and convexity.
What is key rate duration?
Non-parallel shifts in the yield curve, or curve twists, are measured by key rate duration. The yield for a particular maturity on the yield curve changes, holding all other yields constant. The sensitivity of the change in portfolio value to the change in yield in a particular maturity is called “rate duration.” Key rate durations are the contributions to the overall duration from each part of the yield curve.
How to interpret key rate duration
Keeping the yields for all other maturities constant, the key rate duration for a particular maturity is the percentage change in the value of the portfolio for 100 basis point (or bps) or 1% change in the yield for the maturity whose rate has changed. There’s a rate duration for every point on the yield curve, which implies that there isn’t one rate duration but a vector of rate durations representing every maturity on the yield curve. These rate durations are called “key rate durations.”
In the next part of this series, we’ll discuss another measure used to assess risks arising from non-parallel yield shifts. Please read on to find out more.