If you own any bonds, or have exposure to bond funds, perhaps through a retirement account, it’s a good idea to understand how the value of those bonds will react to changes in interest rates.
Recall that owning bonds, or being a lender, entails two primary types of risk: default risk and interest rate risk. Default risk is the risk that the borrower will not be able to repay, leaving the lender out to dry. Interest rate risk is the risk that market interest rates will rise, reducing the value of existing bonds.
Most of us are well aware of the cardinal rule when it comes to bonds: rising interest rates drive bond prices lower, and falling interest rates drive bond prices higher. But how much is the price of your bond or bond fund likely to fall if interest rates rise 1%? Or 2%? What about 5%?
The answer lies in a metric called duration, which helps to quantify interest rate risk. As you can imagine, some bonds are much more susceptible to market interest rate changes than others.
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A bond or bond fund’s duration is calculated based on the specifics of the bond or bonds in question. The calculation includes present value, yield, coupon, maturity and any call features, if applicable. Luckily, individual investors do not need to know how to calculate duration, because it’s a standard data point provided to prospective investors. Bond investors do, however, need to understand how to interpret this metric.
Duration, while measured in years, is actually a reflection of how much a bond’s price will move up or down in response to changes in market interest rates. It’s not a perfect approximation, because there are a multitude of factors involved, but it provides a great way to gauge interest rate risk.
Here’s an example: If a bond has a 5-year duration, its price will decrease in value by 5% if interest rates rise 1%, or rise in value by 5% if interest rates fall by 1%.
If a bond has a higher duration, it means that its price is more susceptible to changes in market interest rates. A bond with a 10-year duration will fall in price by 10% if interest rates rise by 1%, and rise in price by 10% if interest rates fall 1%.
As you can imagine, being in higher duration bonds is great when interest rates are a falling, but can be disastrous in a rising interest rate environment. With interest rates currently suppressed, the small yield that bond owners are earning has the potential to be easily overwhelmed if market interest rates were to rise materially.
I should note that duration only affects the market value of a bond. If you hold a bond to maturity, and the borrower does not default, you will receive the agreed upon interest payments and return of principal.
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Since duration measures the interest rate risk associated with bonds, it would make sense that higher duration bonds generally carry higher interest rates. This is in fact the case, as investors require additional compensation for the added risk.
As a general rule, the shorter a bond’s maturity (time until it is paid off), the lower the bond’s duration. This implies that if you expect interest rates to rise, but still want to own bonds, it would make more sense to focus on shorter-maturity bonds. These will have slightly lower yields, but that will be offset by reduced interest rate risk.
Also, bonds which have adjustable rates typically have shorter durations because the periodic interest rate resets allow the bond to slowly adjust to changing market rates.
As I mentioned, you typically don’t ever have to calculate duration yourself, although online calculators exist if you are so inclined. Instead, you just need to know where to look.
For bond funds, which are typical for 401k and other retirement account holdings, the duration can be found in the fund’s Fact Sheet. It’s usually in the Bond Holding Statistics section. For individual bonds, the duration is often available in documentation from the bond issuer.
One last thing to be aware of is that there are a few different calculations for duration. Often what you will see on a fact sheet is called effective duration, which calculates duration for bonds with embedded options such as whether a bond is callable.
The chart below shows the current yield curve in red. The black shading that you see represents where the yield curve has been recently. Notice that over the last month or so the yield curve has steepened. This indicates that investors have sold off some of their exposure to longer maturity bonds, causing the yields on those bonds to rise.
This behavior may be indicative of investors working to reduce duration risk. As mentioned above, longer maturity goes hand in hand with higher duration, all else being equal, so long-term bonds will be hurt the most if and when interest rates do rise.
The preceding content was an excerpt from Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
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