Duration helps measure the extent of change in the price of bond in relation to one unit of change in interest rates.
Bonds as we all know are sensitive to interest rates. As interest rates rise the prices of existing bonds fall and as interest rates fall the prices of existing bonds rise. This is simply because the new bonds are now yielding higher returns than the existing ones. Similarly, when interest rates fall, the prices of existing bonds rise.
Duration is the interest rate risk associated with a bond. It helps measure the extent of change in the price of bond in relation to one unit of change in interest rates. A bond’s price will fall by 5% if interest rates rise by 1% if the bond’s maturity is five years. In the same case, if the interest rate falls by 1%, the bonds price will increase by 5%.
Duration helps investors calculate the likely changes in the prices of a bond with different maturities and coupon rates based on the changes in interest rates. Coupon rate is rate of interest carried by a bond. Calculating duration helps investors construct their portfolios in a better fashion. Let’s understand the types of duration.
There are three types of duration - Macaulay Duration, Modified Duration and Effective Duration.
Macaulay Duration: It is the time taken to recover the real cost of a bond measured in terms of years by calculating the present value of future cash flows (interest and principal). It was developed by Frederick Macaulay in 1938. It is also known simply as duration. It generally applies to investments where returns are fixed.
Modified Duration: It is a measure of the percentage change in a bond price in relation to a 100 basis change in interest rates.
Effective Duration: It is a refined version of calculating the sensitivity of a bond portfolio by utilizing bond's yield, coupon and final maturity. It is used in portfolios which have callable securities. Callable securities are those which allow the issuer to prematurely ‘expire’ a bond. Issuers may exercise call option by maturing the debt early if the believe that the interest rates are likely to fall. The reason why they exercise this call option is because they’ll be able reissue the debt by offering a lower interest rate and thus cut interest costs.
Points to remember:
- Bonds yielding lower coupon rates are generally more sensitive to interest rate changes than bonds yielding higher interest rates.
- Duration is not the only way to measure a bond’s portfolio as bond prices can change due to credit downgrades/upgrade, liquidity, etc.
However, as easy it may sound, predicting interest rate is tough. As a general rule, it is advisable to invest in short term funds if interest rates are likely to up. If interest rates are likely to go down, then one can invest in longer duration funds to lock in the higher rates. As retail investors may not be able to predict the interest rate movements, it generally advisable to invest in dynamic bond funds which have the flexibility to invest in varying maturities of papers.