February 14, 2013

FINRA Warns on Bonds’ Duration Risk

Duration is not simply a measure of time, FINRA says; it also signals price fluctuation

The Financial Industry Regulatory Authority issued an alert Thursday underscoring the importance of a bond’s duration risk in the current low interest-rate environment.  

“With interest rates hovering near all-time lows, investors should make sure they know their duration numbers," said Gerri Walsh, FINRA’s vice president of investor education, in a statement. "Whether investors own individual bonds or bond funds, they need to understand that outstanding bonds with a low interest rate and high duration may experience significant price drops if interest rates rise."

The alert, Duration—What an Interest Rate Hike Could Do to Your Bond Portfolio, explains that although stated in years, duration is not simply a measure of time. “The duration of a bond or a bond fund also signals how much the price of a bond investment is likely to fluctuate when interest rates move up or down.”

The alert goes on to say a bond fund with a 10-year duration will decrease in value by 10% if interest rates rise 1%. In contrast, if a fund’s duration is two years, then a similar 1% rise in interest rates will result in only a 2% decline in the bond fund’s value.

To find your bond fund’s duration, investors should look on the fund’s fact sheet. Investors holding individual bonds should start by asking their investment professional or the bond’s issuer.

Says the alert: “Investors should also keep in mind that just because a bond or bond fund’s duration is low, it does not mean the investment is risk-free. In addition to duration risks, bonds and bond funds are subject to inflation, call, default and other risk factors.”

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