Why bond duration matters?

The duration of a financial asset that consists of fixed cash flows is the weighted average of the times until those fixed cash flows are received. Duration measures the price sensitivity to the rate of change of price with respect to yield or the percentage change in price for a parallel shift in yields.

The dual use of the word "duration", as both the weighted average time until repayment and as the percentage change in price, often causes confusion. Strictly speaking, Macaulay duration is the name given to the weighted average time until cash flows are received, and is measured in years. Modified duration is the name given to the price sensitivity and is the percentage change in price for a unit change in yield. Modified duration is used more than Macaulay duration. The yield-price relationship is inverse, and the investors would like to know how sensitive the bond price is to yield changes. The modified duration is a measure of the price sensitivity to yields and provides a linear approximation.

The price of bond changes because of two reasons:                                                         

1. The passage of time (convergence towards par). This is of course totally predictable, and hence not a risk.

2. A change in the yield.

Why Bond Duration Matters

For most investors, the primary importance of bond duration is that it predicts how sharply the market price of a bond will change as a result of changes in interest rates. Specifically, when interest rates rise, a bond’s price will fall by an amount approximately equal to the change in the applicable interest rate, times the duration of the bond.

For example, if a 10-year Government security has duration of 6 years, and interest rates for 10-year Government security increase by 1%, the bond’s price will fall by ~6% and if 10-year Government bond interest rates fell by 1%, the bond’s price would increase by ~6%.

Few key points about duration:

·         The longer a bond's maturity, the longer its duration, because it takes more time to receive full payment. The shorter a bond's maturity, the shorter its duration, because it takes less time to receive full payment.

·         The lower a bond's coupon, the longer its duration, because proportionately less payment is received before final maturity. The higher a bond's coupon, the shorter its duration, because a proportionately higher payment is received before final maturity.

·         The duration of any bond that pays a coupon will be less than its maturity, because some amount of coupon payments will be received before the maturity date.

·         Because zero coupon bonds make no coupon payments, a zero coupon bond's duration will be equal to its maturity.

The same concept applies to mutual funds also the investors can choose to invest in the fund as per their risk apatite and view on the interest rates.  The sensitivity of a portfolio of bonds such as a bond mutual fund to changes in interest rates is very important from investors prospective. The average duration of the bonds in the portfolio can be found in the fund factsheets. The duration of a portfolio equals the weighted average duration of all bonds in the portfolio. The portfolio duration can be used to infer how the value of the portfolio would change in response to changes in interest rates.

So if we arrange the fixed income funds of mutual funds in order of their duration (interest rate sensitivity). The liquid funds/ cash management funds will have near zero duration rate risk, so this kind of funds suitable to the investors who want stable returns with daily liquidity option. Ultra short term debt funds have where investment can upto 6 months will have higher interest rate sensitivity than liquid funds. The short term debt funds will have desired portfolio duration of 1-2 will be prone to moderate interest rate risk. The funds like long term gilt funds/ long term income funds will have highest interest rate sensitivity. If an investor expects interest rates to fall during the course of the time of the investment, a long duration fund would be appealing because the funds would offer better return than funds with shorter durations.