If you ever find yourself in a conversation with a fixed income or bond manager and you want to sound sophisticated and bring up a topic near and dear to their heart, bring up the topic of Duration. Before you do that, it is best that you at least know some of the basics of a subject. Read on.
Fulcrum
Duration is very important to bond managers, and it should be to you as well. Duration is the sensitivity of the price of a bond to changes in interest rates. It is different than Term or Maturity. If you buy a 10-year bond that yields 4% and you hold it for the entire 10 years, you will get all of your money back plus the 4% per year of interest. However, if you want to sell the bond prior to Year 10 and interest rates have risen in the meantime, you will not be able to sell your bond for 100 cents on the dollar. You will sell it for fewer than 100 cents because whoever buys the bond will want to earn the higher interest rate. That is Duration risk – the possibility that you won’t get 100 cents on the dollar for your bond if interest rates rise during your holding period.
Duration is expressed in a number of years, and the number of years is almost always fewer than the term of the bond. One of my professors once described Duration as the following: Picture a golf club, probably a driver. Now try to balance the club using one finger, so that the club is balanced horizontally. The point on the club where your finger touches the club, the fulcrum, is the Duration. Because the club head side is heavier than the grip side, that point will not be at the midpoint of the club. Instead, that point will be toward the club head end of the club. Same with Duration – because your cash flow is skewed toward the end of the term, which is when you get your principal back, the Duration of a bond will be closer to the end of the term of the bond than the beginning.
Why Does Duration Matter?
Bonds with longer Duration are more price sensitive to changes in interest rates than are bonds with shorter Duration. It makes sense if you think about it. At one extreme, a portfolio of 30-year fixed-rate mortgages are more price sensitive and therefore have more Duration risk than does a portfolio of 3-month Treasury Bills. Because the coupon rate on the 30-year mortgages can only change every 30 years, the price an investor is willing to pay for that portfolio of mortgages can move up and down significantly as market interest rates change. For the 3-year Treasury Bills, the price risk is not nearly as great because the T-Bills will mature in 3 months so you can then buy new 3-month T-Bills yielding whatever the market rate is at that time.
So, Duration matters to you and your portfolio because, if your Fixed Income or Bond portfolio has a longer Duration, its price may vary as market interest rates change. How do you know if your bond portfolio has a longer Duration? If you have an IRA or 401k, your Fixed Income portion is probably in a “Bond Fund”. Unless your Bond Fund explicitly states that it is a “Short Duration Bond Fund”, your Bond Fund is probably a longer Duration fund and is therefore more subject to Duration risk. If you own individual corporate bonds, you also likely have Duration risk. The shorter your term to maturity, the less will be your Duration risk.
IMO
Duration risk is not a bad thing, but it is something you should be familiar with. If you are a long-term investor with Bond Fund holdings in your 401k, you might not be as concerned with Duration risk right now. However, if you are near retirement and might need your money sooner rather than later, you want to make sure any bond holdings you have are shorter-term and not as subject to Duration risk. If you are retiring in 3 years but your bonds mature in 10 years, you might want to think about reallocating to shorter bonds. Most economists predict rates are going upward, which means prices for bonds that are already issued will be moving correspondingly downward, meaning you may not get your 100 cents on the dollar for your 10-year bonds if you need them in 3 years. If you need help figuring this all out, please contact me!