Mon Feb 18, 2013, 01:58 PM
dkf (37,305 posts)
FINRA investor alert: Duration—What an Interest Rate Hike Could Do to Your Bond Portfolio
If you own bonds or have money in a bond fund, there is a number you should know. It is called duration. Although stated in years, duration is not simply a measure of time. Instead, duration signals how much the price of your bond investment is likely to fluctuate when there is an up or down movement in interest rates. The higher the duration number, the more sensitive your bond investment will be to changes in interest rates.
Currently, interest rates are hovering near historic lows. Many economists believe that interest rates are not likely to get much lower and will eventually rise. If that is true, then outstanding bonds, particularly those with a low interest rate and high duration may experience significant price drops as interest rates rise along the way. If you have money in a bond fund that holds primarily long-term bonds, expect the value of that fund to decline, perhaps significantly, when interest rates rise.
How Duration Risk Affects Price
Many factors impact bond prices, one of which is interest rates. A maxim of bond investing is that when interest rates rise, bond prices fall, and vice versa. This is known as interest rate risk. But just as some people’s skin is more sensitive to sun than others, some bonds are more sensitive to interest rate changes than others. Duration risk is the name economists give to the risk associated with the sensitivity of a bond’s price to a one percent change in interest rates.
The higher a bond’s duration, the greater its sensitivity to interest rates changes. This means fluctuations in price, whether positive or negative, will be more pronounced. If you hold a bond to maturity, you can expect to receive the par (or face) value of the bond when your principal is repaid, unless the company goes bankrupt or otherwise fails to pay. If you sell before maturity, the price you receive will be affected by the prevailing interest rates and duration. For instance, if interest rates were to rise by two percent from today’s low levels, a medium investment grade corporate bond (BBB, Baa rated or similar) with a duration of 8.4 (10-year maturity, 3.5 percent coupon) could lose 15 percent of its market value. A similar investment grade bond with a duration of 14.5 (30-year maturity, 4.5 percent coupon) might experience a loss in value of 26 percent.1 The higher level of loss for the longer-term bond happens because its duration number is higher, making it react more dramatically to interest rate changes.
Duration has the same effect on bond funds. For example, a bond fund with 10-year duration will decrease in value by 10 percent if interest rates rise one percent. On the other hand, the bond fund will increase in value by 10 percent if interest rates fall one percent. If a fund’s duration is two years, then a one percent rise in interest rates will result in a two percent decline in the bond fund’s value. A two percent increase in the bond’s fund value would follow if interest rates fall by one percent.
7 replies, 737 views
Always highlight: 10 newest replies | Replies posted after I mark a forum
Replies to this discussion thread
FINRA investor alert: Duration—What an Interest Rate Hike Could Do to Your Bond Portfolio (Original post)
|Lucky Luciano||Feb 2013||#1|
|Lucky Luciano||Feb 2013||#6|
|Lucky Luciano||Feb 2013||#7|
Response to dkf (Original post)
Mon Feb 18, 2013, 02:11 PM
Lucky Luciano (5,898 posts)
1. A lot of hedge funds have been trying hard to short duration
for a long time (duration?). They have been taking a hit as the cost if carry eats them on their interest rate swaps and swaptions. However, if they can maintain and the economy has a real uptick, then they will make a bloody fortune.
Response to bigapple1963 (Reply #3)
Mon Feb 18, 2013, 06:19 PM
Lucky Luciano (5,898 posts)
6. The 10Y rate is already up 60 bps from the lows.
There comes a point when an improving economy can move yields higher. Bond vigilantes as referred to below are no concern to me unless they can blow up the yields on the US short term date. That is tough to do!