2nd November 2010
Duration is used to measure the extent to which the price of a bond – or a bond portfolio – is affected by future movements in interest rates. It is measured in years and also factors in all of the income received over the course of the bond's life until it is redeemed.
For all fixed income investments, the investor receives a regular income over a defined number of years and, providing the investor holds onto the bond until it reaches its maturity date, he also gets his money back.
Short dated, higher coupon bonds have shorter durations, and long-dated, lower coupon bonds have longer durations. A short duration bond means that the investor will recover their total investment faster than they would with a long duration bond. As a result longer duration bonds are more vulnerable to the level of interest rates.
An income of 5% will look good with 2% interest rates, but poor with 7% interest rates and the bond price needs to factor in that uncertainty.
With longer dated bonds investors have more time to wait before they can recoup their investment.
To reflect this, investors receive what is known as a ‘risk premium' on longer duration bonds, because they incorporate greater economic uncertainty – it is easier to know what will happen in six months, compared to 10 years.
While bonds with a longer duration can make significant capital gains during periods of falling interest rates, the likelihood is that they will lose capital should interest rates start to rise.
Fixed income managers use the yield curve (which reflects market expectations on interest rates) to plot the expected return on bonds with different yields and maturities, allowing them to determine which bonds will deliver the best returns given future market conditions.
Bond prices move inversely to interest rate rises. In most circumstances, when there is a rise in interest rates the change in the capital value of the bond equals its duration multiplied by the percentage movement of the interest rate. This means that when interest rates go down the capital value of a bond will increase.
Using an investment grade bond with a duration measured at 10 years as an example, if interest rates fall by 1%, the bond's capital value would increase by 10%.
Falling interest rates are therefore extremely positive for longer duration bonds. When interest rates rise, the opposite also applies. So, a 1% increase in interest rates would mean the same bond would see its value fall 10%.
Bonds with a shorter duration react similarly, but with less sensitivity, although the movements in value are less severe. If interest rates rose by 1% a bond with a duration measured at two years would see its value fall 2%.
By investing in bonds with different duration, a bond fund manager can ensure a portfolio reflects their view on the future direction of interest rates. For example, if interest rates are expected to rise, they can reduce their holdings in long-dated bonds and increase the weighting in short-dated bonds and vice versa.