Bond duration is an investment concept that average investors genuinely understand, yet it can have a meaningful impact on how your fixed income portfolio performs relative to the bond market as a whole.
Investors tend to shy away from discussions of bond duration because the underlying math is relatively tricky. The good news is that once you look past the math involved, the underlying concept of duration is easily understood.
To make good use of duration when investing in bonds, you don’t need to calculate it — you need to understand the concept. However, before discussing duration further, consider another bond term related to duration: present value.
Present value is what an investment is worth at the moment of evaluation. It contrasts with the value that the investment may have at some future time after it has benefited from compound interest. It acknowledges that investors discount the future value of an investment. Although ten years from now a sum invested at 6 percent compounded annually will be worth much more than the initial investment, investors place a discount on money earned in the future. The basic idea is that money received next year is worth less than cash in hand now and money earned the year after that is worth even less.
Which would you prefer: $100 in your pocket now or the promise of $100 you’ll receive in three years?
For individual investors, the duration is primarily used as a measure of a bond’s sensitivity to prevailing interest rates. It’s defined as the weighted average of the payments an investor will receive over time, discounted to the bond’s present value.
Duration, which is expressed in years, measures how much a bond’s price will rise or fall when interest rates change. The longer the duration, the greater the bond’s sensitivity to interest rate changes. Duration, then, is a particular expression of volatility.
The Impact of Duration on Bond
Duration, which is expressed in years, is a term that investors will encounter when assessing fixed income investments. Typically, portfolio managers will say their portfolio is overweight or long duration, meaning that their duration is higher than that of the benchmark. Alternatively, the portfolio could be underweight or short duration.
A portfolio with a duration that is above its benchmark can be expected to outperform the benchmark if rates are falling, and underperform if rates are rising. Conversely, a portfolio with a below-benchmark duration will typically outperform when rates are rising, and underperform when rates are falling.
Other factors also impact portfolio performance; most notably, the specific market segments in which it is invested — durations of junk bond funds will exceed durations of treasury funds with similar maturities.
Note as well, that duration should be considered a snapshot rather than a permanent aspect of the fund’s strategy.
Investors need to be alert to the risk/reward trade-offs rather than merely using past performances as a gauge of quality.
Short duration funds can be expected to be lower risk / lower yield, while longer duration funds tend to feature higher risk and higher yields.
For investors, the takeaway is that duration – while just one of many factors that can impact the performance of a fixed-income portfolio – is something that nonetheless warrants attention since it is one of the most important factors in the risk profile of any bond investment you might consider.
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