Understanding bond duration

When I review a fixed-income investment, one of the key pieces of information that I pay attention to is the investment’s “duration.” You’ve probably heard this word used loosely in the business media, where it is often confused with the “term” of a fixed-income investment. But duration is something quite different, and can tell you a lot about the interest-rate sensitivity (volatility) of a fixed-income investment, and can therefore be a useful tool in managing fixed-income portfolios.

The “duration” of an investment is defined as the weighted average term to maturity of its cash flows. In other words, the duration tells you, in years, how long it will take before you get your investment back. The longer the duration, the longer it will take before you are paid back.

Another useful characteristic of duration is that it is a great indicator of the potential volatility of an investment. The higher the duration, the more sensitive it will be to movements in interest rates, resulting in higher volatility.

For example, the duration of the FTSE/TMX Universe Bond Index is listed at just over 7 years. This means that for every 1% change in interest rates, the price of the FTSE/TMX would be expected to move by 7% in the opposite direction. If interest rates move higher, the price of the FTSE/TMX would fall, and conversely, if interest rates fall, the FTSE/TMX would be expected to rise.

Factors affecting duration

There are three key things that can affect the duration of a bond.

Time to maturity. As you would expect, generally, the longer until a bond matures, the longer the duration.

Coupon payments. In general, the higher the coupon payments paid by the bond, the shorter the duration.

Yield to maturity. As with coupon payments, the higher the yield to maturity of a bond, the shorter the duration.

Price. All things being equal, the lower the price of a bond, the shorter the duration.

Using duration in portfolio management

Duration is a great tool for understanding the interest rate sensitivity of an investment. When you expect that interest rates are going to fall, you will want to have a longer duration, since the investment will be more sensitive to rates, and will experience a significant increase in price. When it looks like interest rates are going to be on the rise, you would want to shorten duration to protect against capital losses.

That is exactly what active bond managers do. When they expect that rates will be moving lower, they tend to increase the duration in the portfolio. This helps to boost gains as longer duration bonds will rally higher.

Conversely, when they expect that rates are likely to rise, they will generally move in and shorten the duration. Shorter-duration bonds tend to hold up much better when rates are rising, helping to protect your capital much better.

Not a measure of quality

While duration is a very helpful metric to be aware of, it should be pointed out that it is not a measure of quality. You will still want to make sure you have an overall bond portfolio that is in line with your investment needs and objectives.

Courtesy Fundata Canada Inc. © 2015. Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc. This article is not intended as personalized advice. Investments mentioned are not guaranteed and carry risk of loss.