Oct 07, 2022
A bond's price is inversely proportional to its interest rate, so bondholders should be aware of this relationship. Generally, bond prices rise as interest rates fall and fall when interest rates rise, with the opposite being true. The Macaulay bond duration is the average number of years over which its cash flows are expected to accumulate. The modified duration is a percentage change in bond price as a function of a percentage change in interest rates, and it is used to quantify the impact of interest rate changes on bond prices. Bonds' modified durations, rather than Macaulay's, are typically cited when discussing duration. Taking this idea further, the convexity of a bond is a measure of the rate of change in its duration in response to changes in yields. These two indicators can help predict a bond's future performance.
One primary application of duration is to assess how responsive a bond fund will be to changes in interest rates. Specifically, the bond's present value is divided by the weighted average of all future payments. The time frame is measured in years. How much will the price of a bond increase or decrease in response to a change in interest rates? Bonds with longer durations are more susceptible to market fluctuations in interest rates. After purchasing a 30-year bond, you will know that its term is maximum. As the maturity date of the bond draws near, its duration decreases. Initial duration, a measure of how much bond prices shift in response to interest rate fluctuations, is lower for bonds with shorter maturities. Volatility can be measured in terms of duration.
Two distinct concepts can describe the time frame over which a bond is held. The time until all cash flows from a bond are paid is represented by its Macaulay duration, which is a weighted average. The Macaulay duration allows an investor to analyze and compare bonds regardless of their term or time to maturity by taking into account the present value of future bond payments. The second duration type is referred to as "modified duration." Modified duration, in contrast to Macaulay duration, is not expressed in terms of years. The modified duration measures how much a bond's price might shift in response to a one percentage point shift in interest rates. Remember that bond prices are typically thought to move in the opposite direction of interest rates to make sense of changed duration. Bond prices tend to fall as interest rates rise, while bond prices tend to climb as interest rates fall.
When researching mutual funds, you may hear terms like "overweight" or "extended duration" thrown around by the fund management. This signifies that the fund's duration is longer than its benchmark, while the portfolio as a whole may be "underweight" or "short" duration. Bond fund and bond portfolio performance are affected by duration. If rates are falling and it is above its benchmark, its performance should exceed that of the benchmark. With rates on the rise, its performance will suffer. It is common for a portfolio with a duration below the benchmark to perform better during periods of rising rates. When rates decrease, its performance will suffer. To be clear, this is just one of several potential indicators of volatility and risk.
Each bond and bond fund is assigned a duration, which you and your financial advisor can use to evaluate the relative safety of various bond and bond fund options as you build and fine-tune your investment portfolio. Short-term investments may be preferable if you anticipate a rate increase. As an alternative, the Strategic Income Opportunities Fund may be a better bet in this climate because it is less sensitive to interest rate fluctuations than a traditional bond portfolio. Remember that duration is just one of several factors that could influence your bonds' pricing. And that's why we recommend consulting a financial advisor so you can build a portfolio tailored to your specific needs and objectives.
A fixed-income portfolio's return can be affected by a wide variety of variables, the duration being only one. Any bond investment you're considering is one of the most crucial considerations. To managers of actively managed funds, duration is a shifting target. Some investors would rebalance their holdings to center on the benchmark to adapt to market conditions. For this reason, you should treat any duration figure seen in a time-bound source like a Morningstar report or a fund's annual report as a snapshot taken at a specific point in time. It is not a consistent part of the fund's overall strategy. One notable exception is when a fund's investment strategy is predicated on taking a certain stance.