However, as is the case in most situations, sticking to fundamentals and tried and tested methods will take you the majority of the distance when making a decision. In evaluating a bond fund or ETF, in addition to the standardized credit ratings of the underlying holdings (think Moody’s and Standard and Poor’s), one of the key metrics in understanding a bond fund and how it could impact your portfolio is the fund’s average duration.
How to Calculate Bond Duration
In simple terms, a bond’s duration is the weighted average amount of time it takes to receive the expected cash flows; and is a function of the bond yield and the term. Luckily this fact is not very difficult to remember, as the name “duration” stems from the idea that it is simply a measure of the duration of time. The formula itself, however, is not so simple.
- PVi is the Present Value of the ith cash flow
- t i is the time in years until the ith payment will be received
- V is the present value of all future cash flows
- yk is the yield to maturity
- k is the compounding frequency per year
How does bond duration affect my portfolio?
When discussing duration with your advisor or when duration is referenced on a bond fund factsheet, the Modified Duration is typically what they are talking about. This is because the modified duration is a specific calculation for the price sensitivity of your bond or bond fund to movements in interest rates. As an investor, this is a very important metric. A common misconception about bonds and bond ETFs is that they are risk free, or very low risk. Although a strong case can be made that they are usually lower risk that stocks or stock funds; bonds certainly come complete with their own share of risks. Among the primary risks involved in bond investment are credit risk and interest rate risk, the former dealing with how confident investors are with an institution’s ability to make their interest payments and repay principal.
Interest rate risk, however, can be a slightly more difficult topic to wrestle with for new investors. Credit risk primarily has to do with the country or company itself, and so naturally that would have a direct impact on the value of the company’s bonds. Interest rate risk, however, deals primarily with changes happening in the outside world, and how that then impacts the value of the company’s outstanding bonds relative to other bonds and newly-issued bonds.
The rule of thumb to remember is that when interest rates go up, the value of bonds go down, and vise-versa. In other words, they are negatively correlated. Of course, at first glance this seems counter-intuitive. “If interest rates go up, is that not a good thing for bonds? Doesn’t that mean they are paying more interest”. Yes, that is correct for newly-issued bonds, or perhaps some sort of floating rate investment product. However, for investment bonds, they typically have a fixed coupon rate. So, for example, when market interest rates go up (which can be caused by a great many factors, the most famous being actions taken by central banks), newly-issued bonds will have their coupons set accordingly, and older bonds will go down in value, and vise-versa.
For example, take two companies with a similar credit risk. Company A issued bonds 3 years ago at a 5% coupon. Since then market interest rates have gone up, and Company B, with the exact same credit risk, issues bonds at 7%. Because the two companies are exactly the same with regard to credit risk, for their bonds to now be equal investments in the eyes of the market, the secondary market value of Company A’s old bonds would need to decrease, to make up for their less-attractive 5% coupon. Or else, who would buy it? Who would pay the same price for something that pays less interest?
A bond’s duration is the measure of how heavily impacted a bond will be from changes in interest rates.
For example, a bond with a long duration will experience a much larger impact from changes in interest rates than a bond with a short duration.
Think of it this way: if you buy a bond at 1% interest that matures in 30 years, you would have to wait 30 years before receiving your principal back. Let’s say after buying your 1% bond, interest rates for comparable investments go up to 6%. Sure, you could sell your bond in the secondary market, but who would buy it? It would have to be sold for a steep discount to make up for its inferior 1% coupon that the investor would be stuck with for 30 years. Likewise, what do you think would happen if you owned a bond that paid a 6% coupon, and suddenly interest rates for comparable securities dropped to 1%? Investors would be fighting over a chance to hold your valuable 6% interest note, and you would be able to resell the bond at a hefty premium. Consequently, if you hold a bond or bond fund with a reasonably short duration, it will not be as heavily impacted by movements in interest rates. For example, if your bond has a duration of 2 years, and interest rates go up dramatically, you can simply wait out the remaining 2 years of relatively lower returns on your investment (receiving relatively lower interest, but not experiencing a loss of capital), and then receive your principal back at the end of the term, to then be immediately put back to work for you at a higher rate of interest investment.
What does duration mean for my portfolio, today?
Markets have been in a period of low interest rates for nearly a decade now following the financial crisis. Central banks are hinting at a gradual increase of lending rates, and the market is currently pricing in all such possibilities. However, when looking at the history of interest rates, the record is quite clear, once interest rates go low they can very easily stay low for a very long time. This was true throughout the 20th century, and has many examples looking all the way back to antiquity. Given the possibility of both a jump upward in interest rates, and potential for the current low-interest state of affairs to continue dragging on; it would behoove the prudent investor to keep a close watch on the average duration of the fixed income portion of their portfolio.