Maturity – There’s a difference between Maturity and Effective Maturity and it’s an important difference. Maturity measures the length of time in years it takes for a bond to complete payments of interest and principal. Most bonds pay their full face value or principal on the maturity date. The big exception is Mortgage Backed Securities, which pay back principal throughout the life on the bond.
Effective Maturity – Most corporate and municipal bonds with longer maturities give the issuer the right to call bonds, which means to buy them back near face value prior to maturity at certain dates. Effective maturity takes into consideration that bonds with call features will likely have shorter lifespans than their official maturity dates. A bond or bond fund that contains callable bonds will have an effective maturity that is less than its maturity.
Duration – Duration has two definitions:
- The sensitivity of a bond’s price to changes in interest rates
- How long it takes in years for a bond’s income flow (payments of interest and principal) to equal the market price of the bond on a weighted basis.
The second definition is the one that we will be using when comparing duration to maturity. A bond’s duration will never be more than the bond’s maturity date and will almost always less than the maturity date.
Effective duration – Like effective maturity, this calculates duration taking into account the possibility that bonds will be called before maturity.
The longer the duration of a bond or fund, the more sensitive its price or NAV (share price of a bond mutual fund) will be changes in interest rates.
Examples of three AAA rated bonds with 30 year maturities, with very different durations
Zero-Coupon Treasury Bond – This is a bond that has been stripped of its coupon payments. There is no income to the bondholder prior to maturity. In this case, both the effective maturity and effective duration would be the same: 30. A one percent move higher in interest rates would decrease the price of the bond by around 30 percent
Note: Treasury bonds are not callable so their effective maturity and effective duration are the same as their maturity and duration.
Treasury Bond – The effective maturity is 30 years. However, the effective duration is only around 20 years at current interest rate levels. The duration of a normal treasury bond is shorter than a zero coupon bond, because the treasury bond pays interest regularly throughout its life. If yields were higher, the effective duration would be even shorter. A one percent move in interest rates higher would reduce the value of the bond by around 20 percent.
Agency Mortgage Backed Securities – The effective maturity is 30 years. However, the effective duration is around 12 years. In addition to paying interest regularly, Mortgage Backed Securities pay back principal throughout the life of the bond. Like a treasury bond, the higher prevailing interest rates are, the shorter the duration. A one percent move in interest rates higher, would reduce the value of the bond by around 12%.
Conversely, a move lower in interest rates would cause these bonds to gain in value in proportion to their durations, instead of falling.