The Duration of a Bond is one of its most important metrics, as it relates to its characteristics, potential and risk. But the concept of Duration is crucial even for those who do not invest in bonds.
Content
- Introduction
- What does the Duration of a bond tell us?
- Interest Rate Risk
- Reasons to buy High Duration Bonds
- The role of cash in a portfolio
- Conclusión
Introduction
A quick note for the experts reading this post: when I talk about duration, I will be referring to Modified Duration instead of Macaulay Duration.
The duration of a bond is indicated in years. Thus, if we read about a bond with a duration of 8, they are referring to 8 years. A duration of 8 years would indicate that the average wait time to receive the future cash flows of a bond is 8 years. When we speak of a bond’s future cash flows, we mean both interests payments and principal.
While this information may be helpful, duration has a far more important use case.
What does the Duration of a Bond tell us?
The duration of a bond indicates how sensitive the price of a bond is to changes in interest rates. It tells us by how much the price of a bond will change if interest rates increase or decrease.
Remember that the price of a bond and its yield (its interest rate) move in opposite directions. If interest rates go up, bond prices go down. If interest goes down, bond prices go up.
Once we have understood the inverse relationship between price and yield, duration allows us to see how the price of a bond will change if its yield changes.
If the duration of a bond is 8 years, we know that its price will move about 8% for every 1% change in interest rates. For example, if the yield of the bond moves from 3% to 4%, the price will go down by roughly 8%. If the yield were to move from 3% down to 2%, its price would go up by about 8%.
If you are still wondering why it is helpful to know this concept, let me remind you that interest rates and bond prices are constantly moving. Consequently, the longer the duration, the greater the volatility in bond prices. Think about it, the same change in interest rates will move a bond a 20-year duration bond by 10 times more than will a 2-year duration bond.
Let us look at it with two examples:
The first bond has a price of 102, a yield of 1.5%, and a duration of 2 years:
- If interest rates rise by 1% and the bond’s yield reaches 2.5%, the price of the bond would fall by about 2% down to 100.
- If interest rates fall by 1% and the bond’s yield reaches 0.5%, the price of the bond would increase by about 2% to 104.
The second bond is also priced at 102, with a yield of 1.5%, and a duration of 15 years:
- If interest rates increase by 1% and the bond’s yield reaches 2.5%, the price of the bond would fall by about 15% to 86.70.
- If interest rates drop by 1% and the bond’s yield reaches 0.5%, the price of the bond would rise by about 15% to 117.30.
Because the duration of a bond tells us how its price is affected by changes in interest rates, we refer to duration as the metric that measure interest rate risk.
Interest Rate Risk
Interest rate risk, also known as duration risk, is another term to refer to that which is measured by the duration. The higher the duration of a bond, the higher its interest rate risk.
This is because movements in interest rates will affect high duration bonds a lot more than low duration bonds. But remember one important thing, interest rate risk can also be the source of big gains. If interest rates go down, bond prices will increase, and it will be the bonds with the highest duration that will benefit the most.
So far, we have only spoken about the duration of individual bonds. However, fixed income funds or fixed income ETFs, made up of a large number of bonds, also have a duration number. It is calculated by simply taking all of their bonds, similar to a weighted average.
A fixed income ETF with a duration of 3 has much less interest rate risk than an ETF with a duration of 15. We know that the higher the duration, the more the price of a fixed income ETF or fund will move, very much like with a bond.
Additionally, the reason why higher duration is associated with higher interest rate is that higher duration bonds are more exposed to long-term interest rates. And, in general, long-term interest rates are more volatile than short-term interest rates.
While short-term interest rates are mostly managed by central banks, long-term interest rates are set by the free market to a larger degree. And remember that interest rates are mostly affected by economic growth and inflation.
While it is relatively feasible to predict what will happen to the economy in the next 1 or 2 years, it is almost impossible to predict how economic growth and inflation will evolve for the next few decades.
Now that we have discussed the risks involved in investing in bonds with high duration (and, thus, higher interest rate risk), let us look at the reasons why we may want to take on that risk.
Reasons to buy High Duration Bonds
While bonds with high duration have more risk than bonds with low duration, high duration bonds also have more potential for gains. Often, this potential for price gains in high duration bonds is seen as a way to diversify the risk of an investment portfolio.
Let us see why it is attractive to own high duration bonds in our portfolio:
- Higher interest rates: First, and as a general rule, bonds with long maturities and high duration tend to have higher interest rates. This means that we get paid more just by holding them in a portfolio. Remember, however, that this is not the case if we have a flat or inverted interest rate curve.
- Potential for interest rate falls: While a long duration exposes us to greater losses if interest rates rise, it can also offer a lot of potential gains if interest rates fall.
- Diversification: Finally, it should be noted that bonds with high durations, especially government bonds of developed countries, act as a safe haven when there is a recession and stock market crash. It is in those circumstances that interest rates tend to be go down, pushing up bond prices, especially for high duration bonds.
The role of cash in a portfolio
We have already seen what the duration of a bond is, as well as the risks and opportunities associated with it. Let us next speak about cash and the role cash plays in an investment portfolio.
Cash is just a special type of fixed income security. It is like a bond, but with special characteristics.
Like any fixed income instrument, cash has an interest rate or yield and duration. The yield of cash is the interest rate you receive from your bank, brokerage account, or money market fund. This interest rate will be very similar to the official red set by the central bank in that currency. Like the Federal Reserve for US Dollar cash or the ECB for Euro cash.
The duration of cash is 0. This is because that money is available at any time. We do not have to wait to get paid cash, because we already have cash. Consequently, the price of cash is not affected by changes in interest rates.
If your money is in a bank deposit and you have to wait to receive it, then duration is not 0. For a 6-month deposit duration will be about 0.5 years. For a 1-year deposit, duration will be around 1. This means that, while the value of these deposits will theoretically change with movements in interest rates, in actuality it is something we do not have to worry about.
While cash has either 0 or almost 0 duration, it is another diversifying asset in our portfolio. Its price will not increase in the case of a market crash, but it will be dry powder that we can use to buy cheap assets. And cash offers diversification without us taking on any interest rate risk.
Conclusion
As you have already seen, understanding the concept of duration is fundamental when investing in fixed income securities. It is also key when it comes to diversification and portfolio construction.
If you are still wondering if it might make sense to invest a small portion of your assets in bonds, you may want to read the following post I wrote:
Investing in Bonds – Reasons and Risks
And even if you have no interest in investing in bonds, the concept of duration is very powerful to understand how interest rates affect the price of all assets.
While we can measure by how much bond prices will change when interest rates increase, thanks to the duration metric, stocks, gold, or real estate have no defined duration. Nevertheless, their prices are dramatically affected by interest rates.
As a result, while there is no observable duration for non-fixed income assets, you will understand how monetary policy and movements in interest rates are likely to affect the different assets in your portfolio.
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