What impact will rising interest rates have on my bond? When will interest rates rise? Who knows? The central banks seem to change their opinion on how this will affect bond prices. So, in this blog, I will give you an essential word if you are a fixed-income or bond investor. The keyword is duration. I want to cover the duration definition today.
The keyword for bond investors today is DURATION.
Table of Contents
Duration Definition Introduction
To understand the duration definition, let’s talk about bond duration. Bond duration is one of the most important concepts to learn in fixed-income investing. To give it a technical term is pretty horrendous, but it’s a weighted average maturity for all the future bond cash flows. In addition, it measures a bond’s price sensitivity to changes in market interest rates.
In practical terms, duration estimates the impact a 1% change in interest rates could have on a bond’s price. So if a bond’s duration is equal to three, for every 1% increase in interest rates, the bond price will decrease by approximately 3%. So, there’s an inverse relationship between interest rates and the bond cost.
And that’s the key for anyone holding a portfolio of IOUs or bonds. It’s a number; the higher the number, the higher the interest rate sensitivity of the bond you’re considering. And that is about as much as most people want to know about duration.
5-Second Takeaway
- Duration estimates the impact a 1% change in interest rates could have on a bond’s price.
- Duration is a number (i.e.)
- Low coupon bonds tend to have a higher duration. That makes them more interest rate-sensitive.
- Rising interest rates are creating volatility and opportunities in fixed-income bonds.
Two Duration Definition Factors
1. Time To Maturity
The first factor to consider in the duration definition is the time to maturity. How long has the bond got to go until the issuer repurchases it? The longer the time to maturity, the higher the bond duration.
Let me give you an example to explain this concept. Let’s say you loan a friend $100 and give him five days to repay you. You don’t care about interest because you expect your money back in a very short period. You’ll get that money back immediately, and then you can just let it out to someone else.
But you should be concerned if that friend owed you $100 and had 20 years to pay you back. In a scenario like this, you should be worried about market interest rates because it’s 20 years your money is tied up. It’s 20 years that you couldn’t reinvest your money into another venture. So what I am getting at is that the time to maturity is a number you must pay attention to.
2. Coupon Rate
The second factor to remember when considering bond duration is the coupon rate. So, the larger the coupon rate, the lower the duration. Think about it like this: A bond with a high coupon rate means that a high amount of money is paid to you yearly on that bond. In other words, you get your investment return sooner if the coupon rate is higher. Hence, the less sensitive your asset is to duration.
The impact of half a percent change or something you’re looking at that only generates 2% total is more significant than a half percent change or something that’s generating you 10% all right. So, coupon bonds tend to be more sensitive to changing interest rates than those with higher coupon rates. That’s one factor.
Zero Coupon Bond
I think about a zero coupon bond. If you receive no coupons, all the bond payments will happen at the very end of maturity. Hence, it means that the duration definition equals the time to maturity.
So, you could have the highest ratio when all the cash flows are at the end of the investment, like a zero coupon bond.
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Why Are Bonds More Sensitive to Changes in Interest Rates?
The longer you wait to receive your cash, the riskier the instrument is. It’s a Rule of thumb for financial markets. The longer you wait for something, the more risk you take. Suppose you got a coupon bond of 1% with 30 years to maturity. In that case, that will be relatively interest-rate sensitive compared to, let’s say, something with a much higher coupon rate, like 5%, in a much shorter maturity.
Types of Bonds Available
If you want to add bonds to your portfolio, you can choose from individual bonds, bond mutual funds, exchange-traded funds, and other bond-like fixed-income products such as CDs.
Key Risks of Holding Bonds
Interest Rate Changes
Bond prices and interest rates have an inverse relationship. Therefore, a rise in interest rates will tend to push down bond prices.
If you’re holding a fixed income bond/fixed coupon as interest rates rise, the value of your coupon relative to returns you could get elsewhere falls. And this tends to push down bond prices. So, an interest rate rise tends to be bad news for bond prices.
But duration only looks at one side of the bond risk equation; there’s another side, and that is issuer default.
Issuer Default
There’s a risk that you won’t get your money back. Issuer default is the risk of not receiving interest and capital from the bond’s issuing entity.
Luckily, there are rating agencies that specialize in grading bonds. Rating agencies like Moody Standard and Poor do risk ratings, which tells you more about risk issuer default. Just be aware that duration, whatever it is, deals with the interest rate change side of the equation.
Final Thoughts: Duration Definition
You should know the duration definition because, for the first time in decades, we’re seeing yields from bonds similar to yields income-seeking investors might expect from stocks. Moreover, not only are bond yields up, but prices are down, offering opportunities for those with cash to invest.
As recently as October 28, 2022, we’ve seen yields of over 4% for shorter-term Treasury bonds. Additionally, investment-grade corporate bonds are batting 6%, and high-yield corporate bonds are close to 9%.
Duration math is pretty horrible, and honestly, I wouldn’t expect most people ever to want to get their heads on it. But the question is, what does it mean if you’re quoted the number? Ensure you understand the number, as it should guide your investment decisions. Hence, the duration definition.
