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When investing in fixed income securities, it is essential to understand the concept of "duration," which measures the sensitivity of bond prices to changes in interest rates. This measure helps investors understand how bonds react to interest rate fluctuations and how this can impact the performance of an investment portfolio.
Duration is a measure of the weighted average time of the cash flows of a fixed income security. When adapted through a formula (“modified duration”), it represents the sensitivity of the bond's price to changes in interest rates. The greater the duration of a bond, the higher its sensitivity to interest rate changes.
For example, suppose an investor buys a bond with a duration of 4 years and the market interest rate increases by 1%. In this case, the bond’s price will drop by approximately 4%. This happens because investors will require a greater discount to purchase a bond with a lower interest rate than the market rate. Conversely, if the interest rate had decreased, the bond price would have increased by 4%.
Another way to analyze Duration is by considering the time it takes to recover the initial investment made, accounting for both interest payments and the principal. A bond that does not pay interest has a duration equal to its maturity date. On the other hand, a bond that pays periodic interest has a shorter duration. The more frequent and higher the interest payments, the faster the invested amount is returned to the investor, resulting in less price fluctuation due to market movements.
Due to these characteristics, especially its ability to measure a bond’s sensitivity to interest rate changes, a lower Duration generally means lower asset volatility in terms of risk.
A limitation of duration arises when there are significant changes in interest rates. In such cases, the estimated price of the asset based on interest rate changes may deviate significantly from the actual price. This happens because duration assumes a linear relationship between interest rates and bond prices, which may not hold true in extreme situations.
When interest rates experience sharp changes, a new concept can be applied to improve estimation accuracy: the convexity of bonds. Convexity measures the curvature of the relationship between bond prices and interest rates, and becomes more significant as interest rate changes move away from the current point. Thus, in scenarios of large interest rate fluctuations, convexity can provide a more accurate estimate of bond price changes compared to duration.
To illustrate these two concepts, see the chart below:
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When to Consider Adjusting the Duration of a Fixed Income Portfolio
In periods of anticipated declines in interest rates, it may be advantageous to increase the duration of your portfolio to capture gains from the appreciation of bonds. Conversely, in periods when interest rates are expected to rise, it might be prudent to decrease the duration of the portfolio to mitigate the risk of losses. However, it’s important to note that this relationship is not necessarily linear.
Interest rates often change by varying magnitudes across different maturities. For example, a more aggressive cut in the basic interest rates to combat an economic slowdown might result in gains for short-term bonds that are more closely tied to those rates. However, there are no guarantees about how longer-term rates will behave, and thus, bonds with longer durations could experience different, and sometimes opposing, results. This can happen if, for example, the market perceives the interest rate cut as excessive or misaligned with economic conditions.
It’s crucial to make duration adjustments based on a careful and individualized analysis, considering the investor's risk profile and investment objectives. An interesting point to highlight is that the effect of duration also indirectly applies to other asset classes, particularly to equities. In the next article, we will discuss how duration impacts the pricing of stocks.
