What is a Bond duration?
Duration is one of the most important measurements to consider when evaluating a bond or a bond portfolio. However, the concept of duration can appear to be complex, causing many investors to have questions about how duration relates to their fixed income investments.
Because of this, Shenouda believes it is important for investors to gain a thorough understanding of duration and how duration can be used to help assess the appropriateness of a fixed income security within an overall portfolio.
- Duration can help predict the likely changes in the price of a bond, given a change in interest rates.
- By understanding duration, investors can seek to better structure the interest rate sensitivity of their portfolios.
Gauging Interest Rate Sensitivity
Duration is the measurement of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates. This calculation can help predict the likely changes in the price of a bond given a change in interest rates. As a general rule, for every 1% increase or decrease in interest rates, a bond’s price will change approximately 1% in the opposite direction for every year of duration.
For example, if a bond has a duration of 5 years and interest rates increase by 1%, the bond’s price will decline by approximately 5%. Conversely, if a bond has a duration of 5 years and interest rates fall by 1%, the bond’s price will increase by approximately 5%.
|Duration’s Relation to Interest Rate and Price|
|Duration||Interest Rate Change||Approx. Bond Price Change|
Generally, the higher the duration of a bondâ€”the longer an investor needs to wait for the payment of coupons and return of principalâ€”the more its price will drop as interest rates rise. Of course, along with greater investment risk comes the potential for greater returns. If an investor expects interest rates to fall during the course of the time the bond is held, a bond with a long duration would be appealing because the bond’s price would increase more than comparable bonds with shorter durations.
Given its relative ability to predict price changes based on changes in interest rates, duration allows for the effective comparison of bonds with different maturities and coupon rates.
Lower coupon bonds are subject to greater interest rate sensitivity than higher coupon bonds. For example, a 5-year zero coupon bond may be more sensitive to interest rate changes than a 7-year bond with a 6% coupon. By comparing the bonds’ durations, you may be able to anticipate the degree of price change in each bond by assuming a given change in interest rates.
Duration calculations may be utilized to help investors more precisely structure their portfolios in terms of overall investment objectives and risk tolerance.
Considering Duration and Convexity
Duration assumes a linear relationship between bond prices and changes in interest rates, which is not always true in cases of significant changes in interest rates.
In order to compensate for this incongruity, the concept of convexity was developed. In the market, bond prices move inversely to interest rates; bond prices fall as interest rates rise and, similarly, bond prices rise as interest rates fall. Convexity corrects for the error that duration produces in anticipating price changes given large movements in interest rates. Convexity measures the rate of change in duration, thereby fully accounting for the dynamic relationship between prices and rates.
Convexity can also be useful in comparing bonds. If two bonds offer the same duration and yield but one exhibits greater convexity, changes in interest rates will affect each bond differently. A bond with greater convexity is less affected by interest rates than a bond with less convexity. Additionally, bonds with greater convexity will have a higher price than bonds with a lower convexity, regardless of whether interest rates rise or fall.
Duration and Your Portfolio
By understanding duration, investors can seek to better structure the interest rate sensitivity of their portfolio as it relates to their overall investment objectives and risk tolerance. However, duration is only one of many factors to be considered when determining whether a given security is right for your portfolio.
Duration is only meant to describe the interplay between a security’s price and prevailing interest rates. It does not give any indication regarding an issuer’s ability to make interest and principal payments in a timely fashion. A security’s duration is only an estimate, and the change in price in response to an interest rate change may be more or less than indicated by the security’s duration. As with any investment consideration, a security with a given duration may be appropriate for one investor but not for another.
What Does Duration Tell Us?
- The longer a bond’s maturity, the longer its duration, because it takes more time to receive full payment. The shorter a bond’s maturity, the shorter its duration, because it takes less time to receive full payment.
- The lower a bond’s coupon, the longer its duration, because proportionately less payment is received before final maturity. The higher a bond’s coupon, the shorter its duration, because a proportionately higher payment is received before final maturity.
- The duration of any bond that pays a coupon will be less than its maturity, because some amount of coupon payments will be received before the maturity date.
- Because zero coupon bonds make no coupon payments, a zero coupon bond’s duration will be equal to its maturity.
This material is for educational purposes only.Shenouda cannot be held responsible for any direct or incidental loss resulting from the application of any of the information contained herein.
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