(LifeWire) - Will the CEO resign? Will a competitor cut prices? Stock market investors intuitively understand the risks of owning shares of a company.
Holders of bonds face a distinct set of risks that may be less obvious to the uninitiated. Thankfully, one of the biggest risks in the bond market - interest rate risk - is easy to determine, using a concept called duration. It's possible to approximate how much a bond's price is likely to rise or fall when interest rates change, a level of certainty that stock investors will appreciate. So before you go out and buy a 30-year Treasury bond in the mistaken belief that it's risk-free, consider its duration.
A Basic Bond
Before diving in, let's take a simple example of a company that wants to borrow $100. It issues a bond that it sells for $100. To attract investors, the issuer of the bond offers to pay $4 a year to holders of the bond, and will do so for 10 years. At that time, the bond matures, and the bold holder gets $100 back. In the parlance of the world of fixed income, we can say that the bond has a face value of $100, a coupon rate of 4% and a maturity of 10 years.
There are many risks to the holder of the bond. The best known may be the risk that the issuer of the bond can't afford to make interest payments or return the principal. But a default, as this scenario is known, isn't the only risk.
Interest Rate Risk
But even a bond with virtually no chance of default - for instance, bonds issued and backed by the US Government - still have risks. Going back to our simple example, let's say that the day after the bond is issued, interest rates rise to 5%. The owner of that bond might kick herself. If she had waited a day, she could have bought a bond that paid 5% a year. That makes her bond less valuable, and this will be reflected if she tries to sell the bond to someone else. She may not be able to get back her $100.
The seesaw relationship between interest rates and bond prices is a fundamental concept of bonds. But some bonds have greater sensitivity to changes in interest rates. Bond investors don't have to guess at this exposure. A bond's modified duration, a figure derived from several factors, measures this risk and tells the investor how its price is likely to change when market interest rates go up or down. A bond with a duration of six years would be expected to fall 6% in price for every 1% increase in market interest rates.
Elements of Duration
The concept of duration is straightforward: It measures how quickly a bond will repay its true cost. The longer it takes, the greater exposure the bond has to changes in the interest rate environment.
Here are some of factors that affect a bond's duration:
- Time to maturity: Consider two bonds that each cost $1,000 and yield 5%. A bond that matures in one year would more quickly repay its true cost than a bond that matures in 10 years. As a result, the shorter-maturity bond would have a lower duration and less price risk. The longer the maturity, the higher the duration.
- Coupon rate: A bond's payment is a key factor in calculating duration. If two otherwise identical bonds pay different coupons, the bond with the higher coupon will pay back its original cost quicker than the lower-yielding bond. The higher the coupon, the lower the duration.
Using Duration to Your Advantage
Knowing the duration of a bond, or a portfolio of bonds, gives an investor an advantage in two important ways:
- Speculating on interest rates: Investors who anticipate a decline in market interest rates - as a result of, for instance, a stimulative rate cut by the Federal Reserve - would try to increase the average duration of their bond portfolio. Likewise, investors who expect the Fed to raise interest rates would want to lower their average duration.
- Matching risk to your tastes: When selecting from bonds of different maturities and yields, or comparing bond mutual funds, duration allows you to quickly determine which bonds are more sensitive to changes in market interest rates, and to what degree.
Start by determining the value of a bond's yearly cash flow, adjusted to give greater value to payments that are made sooner rather than later. Divide that figure by its price to calculate its duration. Online calculators make this easy.
For More Information
The Securities Industry and Financial Markets Association, a trade group of financial professionals, has posted an article titled Risks of Investing in Bonds, which offers further information on duration risk.
Regent School Press, an academic publisher, offers a technical analysis of bond duration in a PDF file.
Karvy, a financial services company, provides a calculator for figuring how to use bond duration to hedge risks in other investments.