Duration - The word every bond investor should understand
13/08/2014
Bond investors worry about how far and fast interest rates might rise and what impact this could have on the price and yield of the bonds that they hold. In this short video Tim introduces duration, a term that can help to reveal the answer.
These videos do not purport to explain all of these topics in detail and Killik & Co accepts no liability for any reliance placed or investment decisions made from it.
Transcript
Duration – the word every bond investor should understand
Financial markets are full of jargon, and the part of them dedicated to bonds is no exception. So, here I want to cover a key term that needs to be at the top of an investor’s list of priorities when it comes to mastering this area – duration.
The bottom line
Investors in general, including anyone with an exposure to fixed income bonds, tend to worry most often about the direction of interest rates. They want to know two things:
- Where are the heading?
- What will be the impact on my portfolio, either positive or negative?
Bond risks
That is because as a bond holder, one of two key risks you face is a price (and therefore yield) change triggered by a move in interest rates. The reason is that a fixed income security (which most bonds are in practice, whether issued by the government or companies) cannot offer any more, or less, income to compensate – it is fixed, regardless. However, that means when the Bank of England announces a change, the price and yield will move instead in anticipation, with the price rising (and therefore the yield falling) when rates are expected to drop and vice versa (hence the so-called “inverse relationship” between fixed income bond prices and interest rates). Duration captures how far this movement is likely to be in either direction.
The other major risk a bondholder faces is default – an issuer failing to make interest payments or even going bust and not repaying capital. This is measured elsewhere by credit ratings. We will leave that area to one side here.
Diving in
The maths that stands behind duration is pretty complicated and more importantly it is also of limited interest in practical terms unless you are a bond analyst. As such, we won’t be deep diving into it. Much more important is an understanding of the basic principles and the message the number is trying to send.
Concisely, duration is a number which represents “the weighted average maturity for all future bond cashflows.” Behind the maths that sentence implies is a simple concept – an estimate of the impact a 1% change in the Bank of England rate might have on a bond’s price and therefore yield. The higher the duration number, the bigger than change will be and the higher the sensitivity of the bond. So, for instance, a duration of 5 suggests that should interest rates fall by 1%, the bond’s yield will move down (as its price rises by a commensurate amount) by around 5% in response. Other bonds, with lower durations, will respond less aggressively and the reverse is true of those with higher durations.
What affects duration?
Rather than worrying about the maths behind this rather useful number, what most investors want to know is what factors will influence a bond’s duration and make it less, or more, sensitive to interest rate changes. There are two:
- The coupon rate on the bond, and
- The time remaining until maturity (or “redemption”)
In short, the higher the coupon rate on a bond, the lower its duration and vice versa. As for why, if we go back to the definition I mentioned above, a high coupon rate sees an investor recouping more of their initial outlay faster each year than if the bond had a lower coupon rate. This makes it less risky in pure cashflow terms.
Meanwhile, the longer an investor has to wait for a bond to be redeemed, the greater the time risk as the bond’s cashflows are spread further out. As a result, shorter-dater bonds tend to have lower durations, all other things being equal, than their longer dated peers.
That means someone looking for low volatility (low duration) bonds will tend to focus on those with a combination of a relatively short remaining life and a high coupon rate.
Closing out
To close this out, the result is that investors who are defensive will tend to want to limit portfolio risk and therefore duration, especially if they expect interest rates to rise. Equally, their less risk-averse counterparts may be comfortable with higher duration and interest rate sensitivity as should rates fall, they will benefit accordingly.
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