Understanding bond duration and its impact on portfolio risk
Duration is a key concept investors need to understand when investing in corporate bonds and building a portfolio. Quite simply, duration measures the sensitivity of a bond to a change in interest rates. It is measured in years and will vary according to the bond’s maturity date.
Bonds are generally divided into three categories in terms of the length of their issuance, i.e., how long it takes before the bond matures and the principal (the amount that was initially lent to the borrower) is repaid in full.
In general, Australian corporate bonds have maturity dates that are:
- short-term (maturity dates of up to one year)
- medium-term (maturity dates of one to three years), or
- long-term (maturity dates of more than three years).
The longer the maturity (sometimes, confusingly, also known as the duration) of a bond, the more sensitive it is to interest rates – and so the higher the duration and the more the bond’s value will fluctuate as interest rates change. That is because – and again, in general terms – for every 1% increase or decrease in interest rates, a bond’s price will change by approximately 1% in the opposite direction for every year of issuance.
Take the example of a bond that is due to mature in 30 years’ time. If interest rates rise by 1% after the bond is issued, its price will fall by around 30%. Conversely, a bond with a duration of just two years will see its value fall by only 2%.
It is important to note that the coupon rate – the income a bond pays out – also has an important impact on duration. The lower a bond’s coupon, the higher its duration, and vice versa. To put it another way, if you take two bonds that are due to mature at the same time, the one with the higher coupon will have a shorter duration. That’s because it will take less time for the one with the higher coupon to pay back the original cost.
Portfolio construction and duration
Understanding the impact of duration risk is, therefore, vital when constructing a portfolio for clients. Fortunately, since every bond has a duration, it is easy to compare different bonds.
The outlook for interest rates typically depends on the direction of inflation in both the Australian and the global economies. That’s because the fortunes of the Australian and global economies are closely intertwined.
If you expect interest rates to rise, it makes sense to focus on corporate bonds with a short duration – but if you expect them to fall, bonds with a longer duration could be more attractive. Investors can adapt to changing economic prospects – and, in particular, the outlook for interest rates – by actively managing the duration of their portfolios.
It is important to note that duration risk is only one of the factors that could affect the price of a bond. Other key risks include credit risk – the danger that the issuer of the bond might go bankrupt and be unable to pay the interest or repay the principal of the loan. All of these risks have to be taken into account before constructing a portfolio.
Disclaimer: This article contains general advice only. You need to consult with your independent financial, tax and/or legal adviser, and consider your investment objectives, financial situation, and your particular needs prior to making an investment decision. Australian Bond Exchange Pty. Ltd. and its authorised representatives does not accept any liability for any errors or omissions of information supplied in this document except for liability under statute, which cannot be excluded.