What Is Average Effective Maturity?
For a single bond, the average effective maturity (AEM) is a measure of maturity that takes into account the possibility that a bond might be called back by the issuer. For a portfolio of bonds, average effective maturity is the weighted average of the maturities of the underlying bonds.
- Average effective maturity estimates the true maturity of bonds that may be called back.
- Callable bonds allow the issuer to redeem them prior to the stated maturity, thus having lower average effective maturities than stated.
- Knowing the likelihood that a bond may be called is crucial to computing average effective maturity.
Understanding Average Effective Maturity
Bonds that are callable can be redeemed early by the issuer if interest rates drop to a level that is advantageous for the issuer to refinance or refund the bonds. The early redemption of bonds means that the bonds will have their lifespans cut short.
In other words, the bonds will not mature on the stated maturity date listed in the trust indenture. Callable bonds, then, will have an average effective maturity that is less than the stipulated maturity if called.
The average effective maturity can be described as the length of time it takes for a bond to reach maturity, taking into consideration that an action such as a call or refunding may cause some bonds to be repaid before they mature. The longer the average maturity, the more a fund's share price will move up or down in response to changes in interest rates (read our term on duration).
AEM and Bond Portfolios
A bond portfolio consists of several bonds with different maturities. One bond in the portfolio could have a maturity date of 20 years, while another could have a maturity date of 13 years. The maturity at the time of issuance will decline as the maturity date approaches.
For example, assume a bond issued in 2010 has a maturity date of 20 years. In 2018, the maturity date of the bond will decline to 12 years. Over the years, the maturity of the bonds in a portfolio will decline, assuming the bonds are not swapped for newer issues.
The average effective maturity is computed by weighting each bond's maturity by its market value with respect to the portfolio and the likelihood of any of the bonds being called. In a pool of mortgages, this would also account for the likelihood of prepayments on the mortgages. For the sake of simplicity, let’s assume a portfolio is made up of 5 bonds with maturity terms of 30, 20, 15, 11, and 3 years. These bonds make up 15%, 25%, 20%, 10%, and 30% of the portfolio value, respectively. The average effective maturity of the portfolio can be calculated as:
- Average effective maturity = (30 x 0.15) + (20 x 0.25) + (15 x 0.20) + (11 x 0.10) + (3 x 0.3)
- = 4.5 + 5 + 3 + 1.1 + 0.9
- = 14.5 years
On average, the bonds in the portfolio will mature in 14.5 years.
The average effective maturity measure is a more accurate way to get a feel for the exposure of a single bond or portfolio. Particularly in the case of a portfolio of bonds or other debt, a simple average could be a very misleading measure. The weighted average maturity of the portfolio is essential to knowing the interest rate risks faced by that portfolio. For instance, longer-maturity funds are generally considered more interest-rate sensitive than their shorter counterparts.