What is fixed income duration and why is it important?

Posted by The Dopkins Wealth Team | Jun 16, 2015 12:05:40 PM

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 durationsensitivity 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.

___________________________________________________________________

Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

 

Whether you are evaluating wealth management firms or career options or even if you are already a client, you'll want to know what it is that differentiates Dopkins. We think of it as being One Firm. Watch as we articulate The Dopkins Difference and what that means to us and for you.

 

 

Topics: fixed income, fixed income duration, modified duration, effective duration, interest rates

Join Our Mailing List


The Dopkins Wealth Team Dopkins Wealth Management (DWM) is an investment advisory and consulting firm that specializes in providing comprehensive wealth management services by incorporating tax planning, business succession planning, wealth preservation, and wealth transfer into our investment strategies and fiduciary-based solutions. Whether it’s an individual, institutional investor, Corporate 401k plan, foundation or endowment, our clients benefit from our use of an investment strategy grounded in academic research that focuses on long-term success. The key to our client’s success is our ability to understand their unique financial goals and needs, and integrate that with their need, ability, and willingness to take risk to formulate a long-term plan for financial security and prosperity. For more information, contact Tom Emmerling at temmerling@dopkins.com.

More blogs from The Dopkins Wealth Team