SUMMARY:
- The goal of this post is to give an intuitive overview of the concept of duration as opposed to a math centric view found in finance textbooks.
- Duration is the primary metric to assess the interest rate risk of a security or fund.
- The higher the duration of a security or fund, the greater the percentage price change at a given level of interest rate change.
- Interest rates are at historic lows and investors should be aware of the effect of a return to more normal rates will have on their portfolios.
INVESTING LANDSCAPE: Interest rates in developed markets have been in steady decline for nearly 40 years. Central bank actions, aging demographics, just-in-time inventory management, and a more peaceful world have all played a part in keeping inflation, and therefore interest rates, low. This trend has reached an extreme with the market value of negative-yielding bonds in Europe and Japan exceeding $14 trillion. Wise investors know that trends do not continue indefinitely and should protect themselves from injudicious risks. While there are other risks to consider when investing in fixed income, duration outweighs them all.
DURATION DEFINED: Duration is a key metric used to assess the interest rate risk of a fixed-income security, portfolio or index. The longer the duration of your portfolio, the more sensitive it will be to changes in market interest rates. There are two primary measures of duration; both are a reliable gauge to compare interest rate risk in different fixed income instruments. Macaulay duration, expressed in years, measures how long it takes for an investor to recover the price paid for a bond. Modified duration, which is derived from Macaulay duration, estimates a bond’s percentage price change for every 1% change in yield. The two measurements give similar values for shorter-dated securities but start to diverge with longer-dated bonds. CCM utilizes modified duration to ensure clients earn a positive risk-adjusted return.
FIXED INCOME PRIMER: Here are a few reminders about investing in fixed income instruments before looking at an example. The first is that fixed-income security prices move in the opposite direction of their yield. If this is confusing think about purchasing real estate that you rent out for additional income. The lower the purchase price of the rental property, the higher the return (or yield) on your investment. Next, fixed-income securities trade as a percentage of their principal. A price of 98.6, for example, indicates 98.6% of $1000 or $986. Lastly, the dollar return for most fixed-income instruments consists of semi-annual coupon payments and return of principal at maturity. Now let’s move on to a few examples.
DURATION EXAMPLE: I am going to use modified duration as it is the most commonly quoted metric. While a bond’s maturity has the largest effect on duration, coupon and market yield also play a role, especially with shorter durations. I will not go into the details about how duration is calculated as is it beyond the scope of this article. Below are three real offerings in the market as of the 8/27/19.
OBSERVATIONS: The first thing to notice is as the coupon on the bond increases, the duration decreases. This makes sense as an investor would recover more of their investment over a shorter period with a higher coupon. US Treasury Strips make no coupon payments and pay only principal at maturity. Notice that the duration is close to its maturity in years. Secondly, all else equal, the higher the price paid for a bond, the longer the duration. Again this makes sense as you have less principal to recover on the way to maturity.
INVESTING IMPLICATIONS: Most investors in fixed-income will never purchase individual securities and prefer to delegate to a professional money manager. The duration of a fund is calculated by summing the weighted averages of the individual bond durations. Interest rates are currently near historic lows in the US and around the world. Risk-averse investors and those with shorter time horizons should be keenly aware of the interest rate risk in their fixed-income portfolios. The chart at the top illustrates the market value change in the various Treasury benchmarks with changes in market yields. A slight uptick in rates will have a dramatic effect on the value of your investment in longer duration Treasuries. With a yield differential of only .5% between the 2 and 30 year Treasuries, we do not view this as adequate given the level of risk of more normal yields. Interest rate changes can happen quickly as we learned in July of 2016. The 10-Year Treasury note climbed 1.36% to 2.6% over five months. This move meant an almost 10% drop in market value for longer-dated funds. While it can be tempting to pick the fund or manager with the highest yield, as always this must be taken in the context of the level of risk.
