With Government, Corporate and Junk Bonds moving to centre stage in recent months, we thought it worth providing a refresher on duration.
Duration measures the weighted average of the time until each of a bonds fixed cash flows or ‘coupons’ are received. Confusion reigns supreme in discussions about duration, as it is also used to estimate the percentage change in a bond’s as a result of changes in market interest rates. The former version, known as Macauley Duration, finds the present value of the bonds future coupon payments and maturity value. The latter version, also known as modified duration, measures the expected change in a bond’s price to a 1% change in interest rates.
Now this latter point is increasingly important in a low interest rate environment. Whilst many believe that bonds are low risk assets, that offer little chance of negative returns or capital losses, movements in prevailing interest rates, or even the perceived credit risks of companies, can see the value of a bond reduce substantially. This is particularly important in increasing interest rate environments, and reflects the fact that higher returns would be available on newly issued bonds, meaning older bonds, issued at lower rates, must reduce in value to reflect the different circumstance.
Investors should be aware that the longer the duration is, the more sensitive the bond will be to changes in interest rates. If the yield to maturity of a bond rises, the value of a bond with 20 years left will fall substantially more than one with 5 years left.
Applying this to bond indices and managed funds, it’s important to understand that a long duration bond strategy is typically expecting interest rates to fall from their current levels and betting on this through higher duration. On the other hand, a short duration strategy is typically associated with investors expecting rates to increase and are therefore seeking to reduce their exposure with a view to rolling their positions at higher rates in the near future.
As a comparison, the PIMCO ESG Bond Fund carries a duration of 6.94 years, wheras the Vanguard Global Aggregate Bond Fund carries a duration of 7.1 years.