Duration and How It Affects Your Bond Portfolio
Most investors have not heard the term duration associated with their bond portfolios. Due to this fact, most bond investors are unaware of how duration directly affects their investments, either upwards or downwards. Simply stated duration is the name given to associate risk with the sensitivity of a bond’s price to a 1% change in interest rates. Duration is not simply a measure of time but instead signals how much the price of your bond investment is likely to fluctuate with an up or down movement in interest rates. The number associated with duration signifies the sensitivity your bond investment will have due to changes in interest rates.
With interest rates at an all-time historic low many economist believe we will start to see a rise, which in the last month has proven correct. Bonds with low interest rates and a high duration may experience a significant drop in their prices as those interest rates rise. This is also true for bond funds that hold long term bonds. You can expect the bond fund to decline possibly significantly as interest rates begin to rise further. The higher a bonds duration number, the greater the sensitivity to interest rate changes. Simply put, this means that the fluctuation in price whether positive or negative will be pronounced. Naturally if you hold the bond to maturity, you can expect to receive the PAR (or face) value of the bond when the principle is repaid.
However, this may change if the company goes bankrupt or otherwise fails to pay or if you sell before maturity. The price you receive may be affected by the prevailing interest rate and the duration. As an example, if interest rate were to rise over the next year by 2% from today’s rate, a medium investment grade corporate bond with a duration of 8.4 (10 year maturity, 3.5% coupon) could lose up to 15% of its market value. Likewise, a similar investment grade bond with a duration of 14.5 (30-year maturity, 4.5% coupon) may experience a loss of 26% in value. The same affect will occur on bond funds, for example a bond fund will decrease as much as 10% if interest rates rise by just 1%. Conversely, if rates fall by 1% the bond’s price may increase by 10%.
There are other factors that also play into a bond’s pricing, such as lifespan, call features, and yield will all affect the changes in credit. Quality will also play a role in the duration computation. On the other hand, maturity – the length of time before the bond’s principle is re-paid, will also play a role.
In order to determine the duration of your bond or bond fund, look for it in the funds capital Fact Sheet that is often displayed in the Bond Holding Statistics section.
Be cautious because a low duration does not necessarily mean a low risk. In addition, duration is not the only the factor such that bond and bond funds are also subject to inflation risk, call risk, default risk, and other risk factors.