Bond duration is a concept that not all investors truly grasp. It can have a big impact on how your bond mutual fund or fixed income portfolio performs, compared to the bond market as a whole. You might shy away from talk of bond duration because the math is somewhat complex, but the concept is easy enough when you get past the math that's involved.
You don't have to calculate it to make good use of duration when you're investing in bonds. You just need to know how it works.
- Bond duration is used to measure how sensitive a bond fund is to prevailing interest rates.
- Duration is measured in years. It can tell you how much a bond's price will increase or drop as rates change over that time.
- In a falling rate environment, you can often expect good performance from an "overweight" portfolio with a duration that exceeds the fund's benchmark.
- Duration is just one factor that should be taken into account when you're gauging the performance of a fixed-income portfolio.
What Is Present Value?
Bond duration begins with the present value. This is what an investment is worth at a given moment in time. Present value contrasts with the value that the asset may have at some future time after it's earned compound interest. It takes into account the fact that investors discount the future value of an investment.
A sum invested at 6%, compounded annually, will be worth much more than the initial investment 10 years from now, but you place a discount on money earned in the future. The basic idea is that money received next year is worth less than money in hand now. Money earned the year after that is worth even less. Would you prefer $100 in your pocket now or the promise of $100 you'll receive in three years?
Investors use a "discount rate," often prevailing interest rates, to assess how much future cash is worth. This allows them to place a value on each cash payment in a series of cash flows. The higher the discount rate, the less the future cash flows are worth. The lower the discount rate, the greater their value.
What Is Duration?
Duration is used mainly as a measure of a bond fund's sensitivity to prevailing interest rates. It's defined as the weighted average of the payments you'll receive over time, discounted to the bond's present value.
Duration is expressed in years. It measures how much a bond's price will rise or fall when interest rates change. The longer the duration, the greater the bond's sensitivity to interest rate changes. You can conclude that its duration is greatest right after you purchase a 30-year bond. Its duration falls as the bond nears maturity.
Shorter-term bonds have an initial duration, a sensitivity to interest rate changes, that is less than that of longer-term bonds. Duration is an expression of volatility.
Duration's Impact on Bond Funds
Fund managers will tell you that their portfolio is "overweight" or has a "long" duration when you're looking into mutual fund investments. This means their duration is higher than that of the fund's benchmark, but the portfolio could be "underweight" or have a "short" duration instead.
Duration impacts the performance of the bond funds, or a portfolio of individual bonds. You can expect that it will outperform the benchmark if rates are falling, and it's above its benchmark. It will underperform if rates are rising. A portfolio with a below-benchmark duration will often outperform when rates are rising. It will underperform when rates are falling. This is one measure of volatility and risk, but it's not the only one.
Other Factors to Think About
Other factors also impact performance, most notably the specific market segments in which it's invested. The durations of junk bond funds will often be less than durations of treasury funds with similar maturities.
Duration is a moving target for managers of actively managed funds. Some will shift their portfolios around the benchmark target in response to the market. Any duration number from a dated source, such as a Morningstar report or a fund's annual report, should therefore be thought of as a snapshot. It shouldn't be taken as a permanent aspect of the fund's strategy.
The exception is when a fund has a mandate to invest with a particular positioning. Many mutual funds and exchange-traded funds contain the terms "Long Duration" or "Short Duration" in their titles. You should be alert to the risk/reward trade-offs of such funds. Don't simply use their past performance as a gauge of quality.
"Short duration" funds can often be expected to be have lower risk and a lower yield. Longer duration funds tend to feature higher risk and higher yields.
The Bottom Line
Duration is just one of many factors that can impact the performance of a fixed-income portfolio. It's one of the most key factors in the risk profile of any bond investment you might be thinking about.