What is bond duration and why is it important?

The maturity of a fixed income investment, such as a bond, is simply how long it is until the investment is finally repaid. For example, a 10-year bond which has another five years until it is repaid has a five-year maturity. Duration, on the other hand, is a more complicated calculation, which is very useful for analysing and comparing different bonds. The duration of a bond is the weighted average time until all the cashflows from the investment are received, so that whilst the maturity simply looks at the time until the last cashflow is received, the bond’s duration takes into account the size and timing of interest coupons along the way as well as the time until the final principal is repaid.

As an example, a five-year bond, with a 5% per annum fixed coupon will have a duration of around 4.49 years when it is issued, which is less than its five-year maturity. This is due to some of the cashflows being received in years one, two, three and four as well as in year five. The higher the coupon, and the shorter the maturity, the shorter the duration. Zero-coupon bonds, which have no coupon payments, but which are issued at a discount to their value at maturity, have a duration equal to the maturity given that they have only one cash payment on the maturity date.

Duration is important to bond investors because it acts as a guide for how sensitive a bond (or bond portfolio) is to changes in interest rates. For most investors, the bond duration indicates how much the market price of a bond will change when its yield (i.e. its current rate of interest) changes. Specifically, when yields rise, a bond’s price will fall by an amount approximately equal to the change in the yield, multiplied by the duration of the bond. For example, if the yield on a bond with a duration of five years rises by 100 basis points (e.g. from 3% per annum to 4% per annum) the price of the bond could be expected to fall by 5% (e.g. from $100,000 per bond to $95,000 per bond). It is important to remember that yields and prices move in opposite directions so as yields fall bond prices rise and vice versa.

For investors looking to benefit from a fall in interest rates, they will look to buy bonds with a long duration or, in other words, bonds with low coupons and long maturities. On the other hand, investors wanting to avoid interest rate volatility need to find bonds that have low duration or short maturity and high coupons.

Bonds also have different interest rate duration and credit duration. A floating rate bond, where the bond has five years until maturity, with interest coupons reset every 90 days, has an interest rate duration of no more than 0.25 years, however, its credit duration may be between four to five years, implying that the bond price will have very little sensitivity to interest rate changes but is more sensitive to changes in trading margins or credit spreads (i.e. the margin above the 90-day bank bill rate that the bonds trade at).

Investors that are comparing different managed funds or market indices can also look at the portfolio’s average duration which is the weighted average timing of cashflows of all the bonds in the portfolio. This allows investors using managed funds to find funds with greater or lower sensitivity to interest rate changes and therefore they can assess the risk or volatility of the portfolio.

In Australia, the Bloomberg AusBond Composite Index (which is widely used to measure the performance of the Australian bond market) currently has an average duration of about five years. This is up from about three years before the global financial crisis due to the index now having a higher weighting towards bonds with longer maturities and lower interest coupons. With the current average yield on this index of only 2.22% per annum, a rapid 100 basis point rise in average bond yields to 3.22% per annum, would cause the index to fall in value by 5%, all else being equal.

 

Source: Thomson Reuters