Fixed income investors know there is an inverse relationship between interest rates and the price of fixed-income securities. When interest rates rise, prices fall. When rates decline, prices increase. There are a number of risk measures available to give investors a feel for how a specific bond or portfolio of bonds may change in value given a change in interest rates. The best way, though, to measure price sensitivity is to use duration, of which there are multiple types.
Regardless of type, all measures of fixed income duration are expressed in years and are applied as a percentage change in value given changes in interest rates. For example, if a security has a duration of five years, an investor can approximate that if rates increase or decrease by 1 percent (100 basis points), then the value of that security will decrease or increase by roughly 5 percent.
The duration measure used most frequently in fixed income accounting is called modified duration, which provides investors with an approximate change in a fixed income security’s value given a 1 percent change in market rates. Modified duration makes the assumption that a security’s cash flows won’t change as market rates change and works well with securities that lack prepayment options such as U.S. Treasuries.
For securities with prepayment options such as callable agency bonds, callable municipal bonds or mortgage-backed securities, effective duration is the measure investors should use to approximate market value changes. Unlike modified duration, effective duration takes into account how prepayment options can affect a security’s expected cash flows and ultimately its market price given those cash-flow changes.
In the simplest terms, you can think of duration as the weighted-average maturity of the cash flows from a bond or portfolio of bonds. Another important concept to remember: All else being equal, the lower/higher the coupon, the longer/shorter the duration. Thus, bonds with high coupons have less price risk, or volatility, than bonds with lower coupons. Zero-coupons bonds, which pay no interest until maturity, have the longest duration — their duration is the same as their maturity — and thus have the greatest price risk.
Duration allows investors to compare the price risk of bonds that have different maturities, call dates and coupon rates. Careful attention is paid to duration and how it affects a client’s overall portfolio. Portfolios with durations between three and five years typically achieve the best balance between yield and volatility. Contact us to discuss and assess your position.
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