Rule number one: never lose money. Rule number two: never forget rule number one. –Warren Buffett

This simple set of rules is likely one of the driving forces behind many investors’ motivation to invest in bonds. But with interest rates hovering near historic lows, bond holders are acutely aware that a rise in interest rates puts them at risk of breaking rule number one. In an attempt to reduce sleepless nights for these investors, risk measurements like duration have been developed to help estimate how bond investments will react to interest-rate movements.

A Layman’s Perspective

While the calculations for duration can be tricky, the information duration provides is a little more straightforward. Duration tells you how sensitive a bond or bond portfolio will likely be to changes in interest rates. The longer the duration, the more the bond price is expected to change in response to a change in interest rates. And, the shorter the duration, the less sensitive a bond price is likely to be to changes in rates.

Simply put, duration estimates a bond’s expected percentage price change for every percentage point change in interest rates. For example, if interest rates move up 1%, a bond with a duration of six years would expect to see its price decline 6%.

1% (interest rate rise) x 6 years (duration) = 6% (price decline)

Duration combines a bond’s coupon payments, principal repayment, yield to maturity and payment schedule into a single data point that lets you compare interest-rate sensitivity across a variety of bonds.

Additionally, because duration is typically quoted in years, there’s often confusion between duration and maturity. A bond’s maturity is when principal is repaid; duration reflects the weighted average number of years to receive the bond’s future cash flows (interest payments and principal). The weighting of each flow is its present value relative to the bond price. Except in instances where no interest payments are made during the life of the bond (e.g. zero-coupon bond), duration will always be shorter than maturity.

Thinking about duration in terms of the bond’s cash flow can help to make the various factors that influence duration more readily understood.

(Click to enlarge) What's Driving Duration

Flavors of Duration

Unfortunately, when someone says “duration,” it takes a little more digging to make sure you’re on the same page. While there’s no official industry standard, here are some of the most common duration formulas used:

  • Macaulay duration (developed by Frederick Macaulay in 1938) is the most basic duration formula and can be thought of as the weighted average number of years an investor must hold the bond to receive the present value of the bond’s cash flows.
  • Modified duration improves on Macaulay duration by accounting for the fact that market rates, and hence yields, change over the life of the bond.
  • Effective duration or option-adjusted duration, which tends to be the most widely used, improves on modified duration by allowing for changes in the bond’s cash flows that may occur due to provisions such as calls or floating rates.

Duration’s Sweet Spot

Regardless of the formula used, duration works best for small changes in interest rates. The larger the change in interest rates, the more likely the results from a duration calculation will underestimate or overestimate the effect on a bond’s price. That’s because while duration calculates the price sensitivity of a bond, the results are linear. In reality, as yields rise, bond prices fall at a decreasing rate, and vice versa.

Convexity adjusts duration to account for the non-linear relationship between changes in yields and  bond prices. To add to the complexity of convexity, the curve can be positive or negative. Positive convexity is typical for non-callable bonds. Callable bonds and mortgage-backed securities (MBS) may exhibit negative convexity at some price-yield points. This occurs because as yields fall, these bonds exhibit smaller price increases due to the fact that they are more likely to be called, or in the case of MBS, underlying mortgages are likely to be refinanced.

Duration is by no means a stand-alone predictor of how a bond will react. That’s because it completely ignores the effects of other factors like credit quality. For example, bonds with lower credit quality are typically less sensitive to changes in interest rates and more attuned to the stability of the issuer.

Tackling Portfolio Duration

Duration for a portfolio of bonds takes the weighted-average duration of the underlying bonds in the portfolio. But, a portfolio of bonds typically includes securities with a variety of maturities. Since the short, intermediate and long portions of the yield curve don’t always move in tandem, a portfolio’s duration can be less accurate than that of a single bond that contains a single maturity date. The result is that in varying interest-rate environments, a portfolio can have different duration results without changing any of the securities it holds. What’s more, the buying and selling of an actively managed portfolio further complicates the measurement.

An alternative approach is to use empirical duration to measure a portfolio’s sensitivity to interest rates. It’s a bit different in that it’s backward looking and is based on historical data. It uses historical bond prices and yields of US Treasuries with similar maturities to determine the actual duration that a bond or portfolio experienced. The advantage to this approach is that it isn’t dependent on calculations based on assumptions, but rather measures how a bond or portfolio actually responded. However, the results are highly dependent on the historical time period chosen and the data intervals used.

To sum up, duration can be a valuable metric to use in conjunction with other risk metrics to better understand the interest-rate sensitivity of bond investments. Investors should work with their financial advisor to ensure the duration measurements of the fixed income investments in their portfolio are appropriate.

For even more insights into today’s fixed income marketplace, download your copy of the new Franklin Templeton Fixed Income Almanac.

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A Note on Risk

All investments involve risks, including possible loss of principal. Interest-rate movements will affect a bond fund’s share price and yield. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in a fund adjust to a rise in interest rates, a fund’s share price may decline. High-yield bonds and floating-rate loans are generally lower-rated, higher-yielding instruments, which are subject to increased risk of default and can potentially result in a loss of principal. Global and foreign bond risks include currency fluctuations and political uncertainty. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity. Mortgage-backed securities are susceptible to prepayment risk. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. These and other risk considerations are discussed in the appropriate fund prospectus.

Investors should carefully consider a fund’s investment goals, risks, charges and expenses before investing. To obtain a summary prospectus and/or prospectus, which contains this and other information, talk to your financial advisor or visit franklintempleton.com.  Please carefully read a prospectus before you invest or send money.

Franklin Templeton Distributors, Inc.