An introduction to duration

If you’re taking your first steps into the world of bond investing, then the chances are very high that you’ll hear the term ‘duration” almost immediately. But what does it mean and how much impact can it have on your overall investment returns?

Here we look at the concept of duration, explain its relevance to fixed income investing, and highlight other important facts you need to know.

What is duration?

Let’s start with the basics.

Duration is best defined as a measure of the sensitivity of the price of a bond to a change in interest rates. It is expressed in terms of years, with a relatively complex calculation being carried out to determine this figure.

So, why is this important? Basically, the longer a bond’s duration, the more its value is likely to fall when interest rates rise. This obviously has a bearing on your investment decisions.

Why is duration important?

Even this answer is pretty complicated! The unfortunate fact is that bond investing isn’t straightforward. The returns generated are affected by various economic issues.

To understand the topic, you’ll need to grasp how bonds react to movements in interest rates. Basically, they have what can be best described as an inverse relationship with each other.

Therefore, when interest rates rise – as they have been doing this year – bond prices actually go down. When the opposite happens, and interest rates fall, then bond prices will rise.

How duration is used – and a common misconception

Generally, investors find the duration figure useful, because it provides a simple illustration as to how an increase in interest rates will affect bond holdings in their portfolios.

However, it’s important not to get confused between the terms. The duration of a bond is not the same as its maturity date – even though the latter is used to help calculate the former.

The maturity date is simply the point at which the bond issuer must pay back the original value of the bond to its holder. This date is set when the bond is issued.

Duration is affected by the size and timing of future payments on a bond, according to Robeco, the asset management firm.

“For example, the longer the maturity of the bond or the bond portfolio, the higher the duration,” it stated. “The higher the coupon, the lower the duration.”

A coupon is the fixed interest paid on a bond from issue until maturity.

How duration affects bond prices

According to BlackRock, 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 five years and interest rates increase by 1%, the bond’s price will decline by approximately 5%,” it stated.

Of course, the converse is true. “If a bond has a duration of five years and interest rates fall by 1%, the bond’s price will increase by approximately 5%,” it added.

According to Fidelity, bonds with long maturities and low coupons generally have the longest durations.

“These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment,” it stated. “Conversely, bonds with shorter maturity dates or higher coupons will have shorter durations.”

The impact of interest rates

The direction of interest rates – decided in the UK by the Bank of England’s Monetary Policy Committee – will be influenced by various factors.

For example, UK rates have recently risen in response to rising inflation, which is a term used to describe the rapid increase in the overall cost of living.

Raising interest rates helps reduce inflation by making it more expensive for people to borrow money. They’ll then spend less, which results in less demand and slower price increases.

While no-one knows for sure what will happen to interest rates, it’s useful to know how your bond holdings could be affected.

That’s why considering the duration is important.

Duration’s effect on bond buying

So, how should duration affect your bond buying decisions? Well, if you expect interest rates to rise, then you’re more likely to want bonds with shorter durations. This is because they will have less sensitivity to interest rate increases.

Of course, there will be a number of other factors to bear in mind, but duration should always be a consideration.

According to PIMCO, risk-averse investors, or those concerned about wide fluctuations in the principal value of their bond holdings, should consider a bond strategy with a very short duration.

“Investors who are more comfortable with these fluctuations, or who are confident that interest rates will fall, should look for a longer duration,” it noted.

Photo by Sung Jin Cho on Unsplash

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