Bonds and bond funds are often perceived as being safe investments, and buyers typically incorporate them into a portfolio hoping to generate consistent income without the volatility of the stock market. However, fixed-income instruments have many risks beyond the issuer’s credit quality, and it is important to understand how a bond’s duration will cause the price to fluctuate with interest rates.
Investopedia defines duration as “a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.”
More specifically, duration is a number that tells us how much a bond’s price will change based on a 1% shift in interest rates. Duration is measured in years, and as an example, a bond with a 6-year duration will go up or down by about 6% for every 100 basis point (1 percentage point) change in interest rates. The longer the bond and the lower the interest payment, the higher the duration. The formula for duration is complex but you do not need to calculate it yourself. Every bond fund must list its average duration, and you can use this Investopedia calculator to determine the duration on an individual bond.
Managing Duration Risk
This concept is particularly important for bond investors in a low interest rate environment. First, it is critical to remember that past performance is not a predictor of future results. This often used phrase is particularly true of bond funds that maintain a portfolio with a long duration. Bond prices move inversely to interest rates, and over the last couple decades, long-term interest rates have gone consistently lower. This has caused value of the bonds to consistently shift higher.
As a hypothetical example, a portfolio of bonds with 4% interest rates and 20-year durations would have increased in price by approximately 20% as market rates moved from 4% down to 3%. This 20% return is capital appreciation and not income. This distinction is important because if interest rates go back up to 4%, the bond or bond fund would give up those capital gains and the price would retreat back down 20%. Stated differently: the price of a bond, like a stock, can go down in value. The higher the duration, the more volatile the price.
Second, in a low interest rate environment, investors tend to search out new sources of higher income. This is often called, “stretching for yield.” Savers that would have traditionally bought short-term CDs may go into junk bonds with lower credit quality or longer maturity bonds with higher durations in an effort to boost returns. This stretching, when done imprudently, can create a portfolio that is poorly aligned with the investor’s long-term goals and risk tolerance.
Forget Price—I’m Going to Hold to Maturity
Often times investors justify investing in longer bonds (also known as, “going out further on the yield curve”) by saying something like, “I don’t care how much the price moves since I don’t plan on selling the bond.”
Although this statement may be true, it isn’t particularly helpful for managing duration risk. As an example, let us assume an investor buys a $1,000 of a government bond that pays a 1% coupon. Every year the bond will pay the bondholder $10. When the bond matures, the bondholder will get back the $1,000 he put in. Now assume that interest rates go up to 2%, and the new bonds being issued by the government pay $20 per year. If the investor’s 1% bond has 20 years until maturity, the price on the statement will go down by nearly $190—the $10 annual difference between the interest payments multiplied over the remaining 20 years with adjustments for the bond’s cash flows.
So yes, the investor never sold and made 1% every year for 20 years but his income was nearly 20% lower than it could have been had he been able to reinvest at the higher rates. More importantly, if inflation skyrocketed and the change in rates was 10% rather than 1%, the long-term bond buyer would have locked in a negative real return with very little liquidity to take advantage of the more favorable market conditions.
For this reason, it is very important that a bond investor manages duration risk by balancing longer bonds with positions that are less interest rate sensitive. In this way, if interest rates rise, the investor would maintain the liquidity to take advantage of higher rates. If rates stay the same or go lower, the longer bonds will provide steady income and positive returns into the future.
DISCLAIMER: This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.