INSIGHTS

On June 21, 2011

Understanding Bond Duration

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I buy long-dated AAA-rated bonds so my portfolio should be okay, right? Not necessarily. All bond prices react in some manner to forces placed upon them. I am not talking about credit risk or currency risk, or even political risk. These are very important to take into account, but many investors neglect to consider what can be a more sinister enemy, rising interest rates. This is where a bond’s duration comes into play.


Bond duration is a measure of a bond’s sensitivity to changes in interest rates. Over the last few years we have seen historically low rates which have generally rewarded holders of longer maturing bonds with higher prices. This fundamental seesaw relationship, whereby bonds typically fall in value when interest rates rise and rise in value with interest rates fall, is well known. But what happens when rates do move higher? This is why it is important to understand bond duration.


A simple example states that a bond with a duration of 5 years will see a 5% change in price for a 100 basis point move in interest rates. We typically consider a parallel shift in rates meaning the curve moves in the same manner; the 2-year, 10-year and 30-year all move the same amount. So, back to that investor in the beginning with buying long-dated AAA-rated bonds, let’s say, at a 25-year maturity. We will take a current U.S. Treasury trading at $103 with a 4.375% coupon maturing in 2038. The current bond duration is approximately 15 so theoretically when rates increase 100 basis points this bond will lose 15% in value. An upward move by 200 basis points (or 2%) will see this bond shed 30% in value. It can add up quick. Now, I realize this is a pretty extreme example, and many of you will not see such drastic price movements like this, but it is important to at least give a quick look at what you own. There are some ways to lessen duration. One of which is premium bonds which I wrote about a few weeks ago which many advisors are utilizing for this reason.

An investment in bonds is subject to numerous risks including higher interest rates, economic recession, deterioration of the bond market, possible downgrades and defaults of interest and/or principal. Additionally, the financial condition of the issuer may worsen or its credit ratings may drop.



This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog. For additional commentary or financial resources, please visit www.aamlive.com.