Duration & Convexity - Fixed Income Bond Basics | Raymond James
Another risk that bond investors face is interest rate risk--the risk that rising interest rates will make their fixed interest rate bonds less valuable. To illustrate this. market interest rates, bond prices, and yield to maturity of treasury bonds, can help you visualize the relationship between market interest rates and . FInrA Investor Alert: Duration—What an Interest rate Hike Could Do to Your Bond Portfolio. Interest rates and bond prices have an inverse relationship; so when one goes up, the other goes down. The question is: How does the prevailing market interest.
It is called duration. Although stated in years, duration is not simply a measure of time. Instead, duration signals how much the price of your bond investment is likely to fluctuate when there is an up or down movement in interest rates. The higher the duration number, the more sensitive your bond investment will be to changes in interest rates.
If you have money in a bond fund that holds primarily long-term bonds, expect the value of that fund to decline, perhaps significantly, when interest rates rise. A maxim of bond investing is that when interest rates rise, bond prices fall, and vice versa. This is known as interest rate risk. This means fluctuations in price, whether positive or negative, will be more pronounced.
If you hold a bond to maturity, you can expect to receive the par or face value of the bond when your principal is repaid, unless the company goes bankrupt or otherwise fails to pay. If you sell before maturity, the price you receive will be affected by the prevailing interest rates and duration. A similar investment grade bond with a duration of Using a bond's duration to gauge interest rate risk While no one can predict the future direction of interest rates, examining the "duration" of each bond, bond fund, or bond ETF you own provides a good estimate of how sensitive your fixed income holdings are to a potential change in interest rates.
Investment professionals rely on duration because it rolls up several bond characteristics such as maturity date, coupon payments, etc.
Duration is expressed in terms of years, but it is not the same thing as a bond's maturity date. That said, the maturity date of a bond is one of the key components in figuring duration, as is the bond's coupon rate.
In the case of a zero-coupon bond, the bond's remaining time to its maturity date is equal to its duration. When a coupon is added to the bond, however, the bond's duration number will always be less than the maturity date. The larger the coupon, the shorter the duration number becomes.
Updated: Duration—What an Interest Rate Hike Could Do to Your Bond Portfolio
Generally, bonds with long maturities and low coupons have the longest durations. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment.
Conversely, bonds with shorter maturity dates or higher coupons will have shorter durations. Bonds with shorter durations are less sensitive to changing rates and thus are less volatile in a changing rate environment. Why is this so?
Because bonds with shorter maturities return investors' principal more quickly than long-term bonds do. Therefore, they carry less long-term risk because the principal is returned, and can be reinvested, earlier.
Duration and Bond Interest Rate Risk
This hypothetical example is an approximation that ignores the impact of convexity; we assume the duration for the 6-month bonds and year bonds in this example to be 0. Duration measures the percentage change in price with respect to a change in yield. FMRCo Of course, duration works both ways. If interest rates were to fall, the value of a bond with a longer duration would rise more than a bond with a shorter duration.
Using a bond's convexity to gauge interest rate risk Keep in mind that while duration may provide a good estimate of the potential price impact of small and sudden changes in interest rates, it may be less effective for assessing the impact of large changes in rates. This is because the relationship between bond prices and bond yields is not linear but convex—it follows the line "Yield 2" in the diagram below.
This differential between the linear duration measure and the actual price change is a measure of convexity—shown in the diagram as the space between the blue line Yield 1 and the red line Yield 2.
Relationship between price and yield in a hypothetical bond The impact of convexity is also more pronounced in long-duration bonds with small coupons—something known as "positive convexity," meaning it will act to reinforce or magnify the price volatility measure indicated by duration as discussed earlier.
Keep in mind that duration is just one consideration when assessing risks related to your fixed income portfolio.