Many investors look at bonds in very simplistic fashion. If the obligation generates enough yield and is from a familiar issuer, it may be a no brainer buy for many. For the more discriminating bond investor, a number of data points will enter into the picture: yield, maturity, credit profile, call protection, forward outlook for the issuer — just to name a few.
One of the typically overlooked, but critical, bond performance statistics is duration. Many investors tend to confuse or interchange maturity with duration. Maturity strictly refers to the length of time until a bond is repaid, while duration is a calculation that evaluates the sensitivity of a bond’s price to interest rate fluctuations. Duration, measured as a number of years, tells us how quickly an initial bond investment will be repaid – measured by interest payments and principal recapture. It also tells us what might happen to interim bond price if rates move up or down by 100 basis points.
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For instance, let’s say that today we are buying a bond with 10-year maturity with a coupon (interest rate) of 5 percent. If we plug those details into a bond duration calculator like this one, we find that the duration of the bond is 7.99 years, assuming semi annual interest. The duration calculation is affected to an extent by the frequency of bond payments. If our interest were paid annually, the duration would be higher – if interest were paid quarterly, duration would be lower.
With a duration of 8 years, the aforementioned bond would move in price by 8 percent when interest rates move by 100 basis points in either direction. So if we bought the bond at par (100) and interest rates spike by 100 bp the day after we buy the bond, it would be valued somewhere around 92. During the life of the bond, as it moves towards maturity, duration declines, and so does its interest rate sensitivity. Even if rates continue to rise, there will come a point where the bond’s value will increase as it creeps closer to maturity.
Duration can be measured with pooled bond assets as well. Mutual funds, ETFs, and closed-end funds will typically advertise a fund’s blended duration, which gives investors a good idea how much risk they are taking. For instance, let’s take a look at two of Vanguard’s bond ETFs, its Short-Term Bond ETF (BSV- .96% yield) and Long-Term Bond ETF (BLV- 3.83% yield).
If we examine the composition of both funds, we see both exhibiting investment grade characteristics, however, the durations vary drastically. The short-term fund posts a duration of 2.7 years while BLV has a blended duration of 14.5 years, with associated average maturity of 24 years. So while you are getting around 4X as much yield with BLV, you are taking on nearly 5X as much duration risk. If interest rates were to rise by 200 basis points, you’d take a 30% interim hit on BLV versus only a 5.5% interim loss on BSV.
While it would have been best to take on tremendous duration risk over the past 30 years as interest rates have slowly, but steadily declined, you do not want to be holding long duration bonds during an interest rate upcycle. Though technically you lose nothing if you hold to maturity, there is tremendous opportunity cost in sitting on long duration paper as interest rates spike.
Despite the continued cries over the past several years that investors should fear higher interest rates, there appears no signal that an overly hawkish environment is in our midst. Still investors need to consider the consequences of ‘going long and being wrong’ about rates. And that means understanding the effect bond duration can have on a portfolio.
About the author: Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.