By David Koch, CFP®, AIF®, CFA, Senior Wealth Advisor
Part 4, Common Risks with Bonds – Duration Risk
Like a seesaw, bond prices move inversely with interest rates. Interest rates move down = bond prices move up. Interest rates move up, bond prices move down. This is called duration risk, or interest rate risk. Let me explain why this is so.
Like we mentioned in Part 2, bond yields are a function of the interest rate earned on U.S. government bonds plus an additional charge to take on the credit risk, called the spread. But besides the amount of the spread, those underlying interest rates on the Treasuries are ever-changing as well.
A quick example
If you lend a company $1,000 for 10 years at 5%, and then rates drop and the going rate to lend to the same or a similar company drops to 4% – your 5% bond just got more valuable. The inverse is also true. If you lock up a 10-year bond for 3%, and then rates go up to 4%, your bond got less valuable.
If current rates rise, for example, no one is going to pay you face value for that same bond when they can go buy a new one with a better interest rate. It’s as simple as that, and the estimated change in price for a 1% move in rates is called “duration.”
If someone says that the duration of their bond portfolio is 5, then you should expect that if interest rates were to go up 1%, then the value of that portfolio would drop by 5%. This kind of estimate is a little bit of a round-peg/square-hole problem: But it is an estimate, and a measure of risk in your portfolio.
If you own a portfolio of bonds that all mature next year, then your duration will be small, also known as short duration. In this case, it doesn’t matter a whole lot what interest rates do. Your portfolio’s value won’t fluctuate much because the bonds are going to mature soon and you’re going to get your par value back soon.
Duration and maturity
But if you own a portfolio of bonds that are going to mature far out in the future, duration can be a much bigger issue. This is balanced with the fact that in order to entice lenders to lend for longer time periods, longer-duration bonds tend to pay more.
For example, you can almost always find a better rate on a 2-year CD than a 6-month CD. Same goes for mortgages. You can almost always find a better rate on a 15-year than a 30-year. If borrowers want to borrow for longer periods of time, lenders want to be compensated more for taking on duration – that interest rate risk.
The yield curve
For any given credit risk, there isn’t just one interest rate, there are many: from short-term rates to long-term rates. This spectrum of rates is called the “yield curve” because in normal times rates curve up from lower short-term rates, to higher long-term rates. Think about going from low-yield, short-term CD rates on one end (like 0.5%), to higher-yield mortgage rates on the long end (like 4.5%).
One way to mitigate duration is to keep all your maturities short. If all your bonds mature in, say, less than two years, you’re going to limit how much your bonds’ values will change if there is a change in interest rates. This will also, however, likely result in a lower yield since short-term bonds tend to earn less than longer-term bonds.
There are ways to approach investing in bonds that provide a trade-off between the two, which I’ll cover next in Part 5. This final post will discuss the considerations involved with building a portfolio of bonds.
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