Duration – Current income opportunities
Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
Duration is an often confused term when it comes to financial fixed income investing. After all, in your everyday life, the definition of duration is the length of time it takes for something to occur. To add to the confusion, there are multiple variations of duration in the investing world, only some of which are measures of time. In fixed income investing, duration most often refers to modified duration, and investors must understand its impact on the fixed income holdings in their portfolios.
Simply put, modified duration is the measure of a bond’s price sensitivity to changes in interest rates. It is not a calculation of time, nor should it be referred to in years or any other length of time.
If a bond has a duration of 3, its price will change ~3% for every 1% (or 100 basis points) change in interest rates. If interest rates were to rise 2% (or 200 basis points), the price of the bond would fall by ~6%. Keep in mind the inverse relationship between a bond’s price and interest rates. Conversely, if interest rates were to fall 1%, the price of the bond would rise by ~3%. It is measuring the bond’s price sensitivity, not its maturity.
The higher a bond’s duration, the more its price will adjust as a result of changes in interest rates. Duration is nonlinear – it will decrease as a bond approaches its maturity. Both time to maturity and a bond’s coupon rate affect bond duration. All other factors being equal, a bond with one year left to maturity will have a lower duration than a bond with eight years left to maturity. There is less interest rate risk associated with the shorter bond, and therefore its price will be relatively more stable. All other factors being equal, a bond with a higher coupon will pay back an investor’s original investment more quickly and therefore have less interest rate risk and a lower duration.
Why does duration matter? For the last year or so, we have suggested that extending out in maturity and therefore taking on more duration risk is a long-term positive for optimizing return. The motivation is to boost long-term yield (increase income) and capitalize on higher yield opportunities for an extended period while interest rates remain elevated. Although higher durations expose investors to more price sensitivity, a couple of factors are considered. Many investors buy and hold individual bonds until they mature. In that case, price movements are not realized when held to maturity. The risk to price movement only matters if the bond is sold before its maturity. As each bond approaches maturity, its duration will decrease.
Adding duration is a calculated risk, and currently, it allows investors to capture income that wasn’t available for the better part of the last two decades. Individual bonds will always serve the purpose of helping to preserve investor capital, but today’s economic environment has allowed investors to capitalize on the income opportunity that higher-duration bonds offer.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
Investment products are: not deposits, not FDIC/NCUA insured, not insured by any government agency, not bank guaranteed, subject to risk and may lose value.
To learn more about the risks and rewards of investing in fixed income, access the Financial Industry Regulatory Authority’s website at finra.org/investors/learn-to-invest/types-investments/bonds and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) at emma.msrb.org.