All investments involve some level of risk – and managing that risk is an important part of your overall investment plan. If you’re looking to minimize risk by allocating to bonds, there’s an important term you should know and understand: duration. You may be asking, “What does it mean, and how does it affect my investment choices?”
To answer these questions, you must first understand how bonds are impacted by interest rate changes. If you hold a bond paying a five percent interest rate, but rates then fall to four percent, that bond you own is more valuable than one you could purchase on the open market. After all, five is better than four. On the other hand, if rates rise, the bond you currently own is less valuable than new bonds paying larger yields.
Duration measures (in years) how drastic the rise or fall of your bond’s value may be when interest rates move. It’s a valuable tool to measure your bond’s interest rate risk. Typically, the higher the duration, the more the bond’s value will fall as rates rise. Bonds with a lower duration are usually less sensitive to rising or falling rates.
If a bond’s value falls, how attractive will it be on the open market? No one will be knocking down your door if the market is full of bonds paying higher interest income. In that case, you are stuck with a bond decreasing in value or are forced to sell it at a discount.
If you expect current interest rates to continue their march higher, bonds with a shorter duration may be appealing as they would pay back their principal sooner, letting you purchase new bonds with higher potential income and potentially less interest rate sensitivity.
Why duration is important
Duration is a valuable tool if you plan to sell your bonds prior to maturity. No matter what happens to interest rates, if you buy a 20-year bond for $2,000, you will get back your principal after 20 years. However, if you plan on selling that bond before that end date, you will want to keep tabs on how interest rate risk may impact your bond portfolio.
If you aren’t bothered by volatile markets, consider long-duration bonds. If you’re risk-adverse, bonds with a shorter duration may be a better bet. If you want to avoid this juggling act altogether, there are alternative fixed-income solutions with very short durations, like senior secured loans. These loans are benchmarked to LIBOR and adjust to changes in interest rates typically every 90 days.
Duration is just part of the equation
Keep in mind that duration only measures one part of overall bond risk.1 It’s important to look at a bond’s credit risk, as non-investment grade securities like some high-yield bonds react to investor concerns about defaults as much as they do to changes in interest rates. You will also want to examine a bond’s liquidity risk by determining if there’s a robust seller’s market. Government bonds may find many available buyers, but the same isn’t always true for corporate bonds.2
Generally, if you’re looking at fixed-income securities for risk-adjusted income during periods of market volatility, make sure you factor interest rate risk into the equation. Every bond and bond fund has a duration, so knowing this number may be a useful tool when determining your appetite for interest rate risk. While many bonds are perceived as “safer” investment, those susceptible to rising rates may see a loss in value.