What is Bond Duration?

Rick Welch |

As defined, bond duration “is the sensitivity of a bond’s price to changes in interest rates.” Many investors confuse bond maturity with duration. In fact, maturity is just one factor that must be taken into account when considering bond duration. Other factors include coupon rate and frequency, bond yield and any call features written into the bond. Like maturity, duration is also expressed in years.

The owner of a bond is entitled to a series of cash flows. For coupon bonds, the cash flows start with the payment of the semiannual coupon for each remaining year of the bond’s term. Coincident with the final coupon payment is the return of the face value of the bond. In the case of coupon bonds, duration is always less than maturity. To calculate duration, we determine the present value of the bond’s cash flows and divide that figure by the price of the bond. Considered in this context of cash flows, duration could also be defined “as the length of time before an asset is due to be repaid.” I like to think of bond duration in more simple terms, as in when I get my money back.

In 2020, we saw the interest rate on the benchmark 10-year US Treasury fall from 1.91% to as low as 0.50%. As the Covid 19 virus is contained and vaccine distribution here in the US accelerates, we expect that interest rates will start to rise as prospects for the domestic economy improve.  As of this writing, we have a 2021 year-end target for TNX of about 2.00%. As interest rates rise, the prices of fixed income securities, like bonds, fall. Many investors look to the 1% rule which suggests that for every movement of 1% in interest rates, bond prices will change (in the opposite direction) in an amount roughly equal to their duration. For example, the price of a bond with a five (5) year duration will fall by about 5% if interest rates rise by 1%. It is important to note, however, that bond yields do not change uniformly across the yield curve in times of changing rates.

Duration then provides an easy way to compare bonds or evaluate a portfolio of bonds. Bonds with a longer maturity will have higher duration, which in periods of rising interest rates can translate into higher interest rate risk. A higher coupon bond will have lower duration than one with a lower coupon rate because the cash flows from the higher interest payments mean the face value of the bond is repaid sooner.

Low or moderate duration strategies are appropriate during periods when we expect interest rates to rise. We are currently recommending a “low to the ground” approach for bond portfolio duration with a target duration in line with that of the Barclays US Aggregate Bond Index or just under 6 years. This type of approach suggests a reduction in intermediate and long-term bond holdings, particularly US Treasuries, is the way to go. Some alternative fixed income strategies like convertible bonds and floating rate bank loans may be appropriate for some investors. Adding some high yield bonds is another way to lower overall portfolio duration.  In general, during periods of rising interest rates, active management of fixed income assets is preferred over a more passive approach.

Let’s test your understanding of duration. With a zero-coupon bond, is the duration less than, greater than or equal to maturity? The correct answer is that with a zero-coupon bond, duration is equal to maturity as the only cash flow from the bond is the one-time payment of principal and interest upon maturity.