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Understanding bond 'duration'
4/20/2019 6:29:43 AM
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Objective research, analysis, and insight on investment funds in Canada from an acknowledged industry expert

By Dave Paterson  | Wednesday, April 15, 2015


When I review a fixed-income investment, one of the key pieces of information that I pay attention to is the investment’s “duration.” You’ve probably heard this word used loosely in the business media, where it is often confused with the “term” of a fixed-income investment. But duration is something quite different, and can tell you a lot about the interest-rate sensitivity (volatility) of a fixed-income investment, and can therefore be a useful tool in managing fixed-income portfolios.

The “duration” of an investment is defined as the weighted average term to maturity of its cash flows. In other words, the duration tells you, in years, how long it will take before you get your investment back. The longer the duration, the longer it will take before you are paid back.

Another useful characteristic of duration is that it is a great indicator of the potential volatility of an investment. The higher the duration, the more sensitive it will be to movements in interest rates, resulting in higher volatility.

For example, the duration of the FTSE/TMX Universe Bond Index is listed at just over 7 years. This means that for every 1% change in interest rates, the price of the FTSE/TMX would be expected to move by 7% in the opposite direction. If interest rates move higher, the price of the FTSE/TMX would fall, and conversely, if interest rates fall, the FTSE/TMX would be expected to rise.

Factors affecting duration

There are four key factors that can affect the duration of a bond.

Time to maturity. As you would expect, generally, the longer until a bond matures, the longer the duration.

Coupon payments. In general, the higher the coupon payments paid by the bond, the shorter the duration.

Yield to maturity. As with coupon payments, the higher the yield to maturity of a bond, the shorter the duration.

Price. All things being equal, the lower the price of a bond, the shorter the duration.

Using duration in portfolio management

Duration is a great tool for understanding the interest rate sensitivity of an investment. When you expect that interest rates are going to fall, you will want to have a longer duration, since the investment will be more sensitive to rates, and will experience a significant increase in price. When it looks like interest rates are going to be on the rise, you would want to shorten duration to protect against capital losses.

That is exactly what active bond managers do. When they expect that rates will be moving lower, they tend to increase the duration in the portfolio. This helps to boost gains as longer duration bonds will rally higher.

Conversely, when they expect that rates are likely to rise, they will generally move in and shorten the duration. Shorter-duration bonds tend to hold up much better when rates are rising, helping to protect your capital much better.

Not a measure of quality

While duration is a very helpful metric to be aware of, it should be pointed out that it is not a measure of quality. You will still want to make sure you have an overall bond portfolio that is in line with your investment needs and objectives.

Next time: In my next Due Diligence article, I’ll look at a few ways to manage the bond duration of your fixed-income portfolio.

Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc., a consulting firm specializing in providing research and due diligence on a variety of investment products. He is also the publisher of Dave Paterson's Top Funds Report and Mutual Fund and ETF Update, offering regular commentary and in-depth analysis of Canada’s top investment funds. He uses a unique analytical approach to identify funds with strong, risk-adjusted returns, and regularly publishes his insights and analyses in Fund Library.

Notes and Disclaimer

© 2015 by Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.

Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. No guarantee of performance is made or implied. This article is for information purposes only and is not intended as personalized investment advice.

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