Bonds 102: The Importance of Duration in Bond Investing
What you will learn
- What duration is and how bond managers use it
- How investors can use duration to guide investment decisions
- Factors to consider when choosing a bond portfolio based on duration
- The limitations of duration
What is duration?
There are various factors investors should consider when assessing the risk of a bond. One of the most common is duration, which quantifies the sensitivity of a bond or bond portfolio to changes in interest rates. Given that interest rates are the main drivers of bond pricing, duration is considered a key measure of risk, as explained below.
Expressed in number of years, duration takes into account a bond’s yield, coupon, maturity and call features.
The duration of a bond provides an indication as to how far the bond’s value will fall if interest rates rise. Generally, bonds with a higher duration will lose more value than bonds with a lower duration.
There are a number of ways to calculate duration, but the term is generally used to refer to “effective duration.” This shows the approximate percentage change in a bond’s value in response to a percentage point change in yield. For example, a bond with a one-year duration would lose 1% of its value if rates were to rise by 1%. In contrast, a bond with a five-year duration would lose 5% of its value if rates were to rise by that same 1%.
It works the opposite way when interest rates fall so that higher-duration bonds experience a greater increase in value compared to lower-duration bonds. For example, a bond with a one-year duration would gain 1% in value if rates were to drop by 1%. However, a bond with a five-year duration would gain 5% in value if rates were to drop by that same 1%.
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GAUGING INTEREST RATE SENSITIVITY Bonds with longer durations experience greater value fluctuations |
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1% rise in rates |
1% drop in rates |
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Duration |
% NAV change |
Resulting Value |
Duration |
% NAV change |
Resulting Value |
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1 year |
-1% |
$990 |
1 year |
+1% |
$1,010 |
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5 years |
-5% |
$950 |
5 years |
+5% |
$1,050 |
|
10 years |
-10% |
$900 |
10 years |
+10% |
$1,100 |
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Initial value of $1,000 |
The duration figures quoted do not relate to any specific PIMCO product |
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For Illustrative Purposes Only |
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How do bond managers use duration?
Duration can be an extremely useful tool for bond managers when building portfolios and managing risk. As the economic outlook changes, the portfolio manager can adjust the average duration in the bond portfolio to suit investment objectives.
These adjustments can be made to the portfolio as a whole or to a particular sector within the portfolio. A manager who expects interest rates to fall will likely extend the duration of the portfolio, and vice versa.
Managers who are confident that interest rates will rise may even adopt a “negative” duration strategy in order to maximize any increase in value.
How can investors use duration to guide investment decisions?
Investors should consider their appetite for volatility and their views on the future direction of interest rates.
Risk-averse investors or those concerned about large fluctuations in the value of their holdings should consider a short duration bond strategy. If an investor expects interest rates to increase during the life of a bond, shorter duration bonds may be sensible investments.
Investors who are more comfortable with risk or those who expect interest rates to fall during the life of the bond, may find longer duration bonds appealing.
What are factors to consider when choosing a bond portfolio based on duration?
Investors looking for a professionally managed bond portfolio may have the option of choosing a strategy based on duration. Typical options include:
Portfolio types and average duration
- Low-duration
Average duration: 1-3 years
Often used as a higher yielding alternative to money market funds in a low interest rate environment. - Moderate-duration
Average duration: 2-5 years
For investors who are prepared to take on a little more risk in pursuit of returns that are higher than money market or short-duration portfolios. - Long-duration
Average duration: 6-25 years
Used by investors as a relatively stable alternative to equities or as a way of matching the duration of their portfolio to their liabilities.
What are the limitations of duration?
Duration is a very useful tool for assessing the risk of a bond, but investors need to remember it is not complete. For example, it doesn’t consider the credit quality of the issuer.
Another limitation is that the average duration of a portfolio of bonds may change as different bonds in the portfolio mature and interest rates change. Concerned investors should regularly check the average duration of the strategy or invest with a manager who actively manages duration according to a set range.
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