Rates Are Rising: Bond Fund Duration Is Important

by: Richard Shaw

Duration indicates the amount by which a bond is expected to change in price with a 1% change in interest rates. Why is that important? What is the duration of 2-year and 10-year Treasury bonds today? How might those bonds change in price? What are the durations of popular bond funds?

At the current 4% yield, the 10-yr Treasury has a duration of 8.44 yrs, and at the current 1.18% yield the 2-yr Treasury has a duration of 1.99 years.

That means that if the 10-yr rate went up 1% from the current 4% to 5%, the 10-yr Treasury would be expected to decline in price by 8.44%, and if the 2-yr Treasury rate went up 1% from current 1.18% to 2.18%, it would be expected to decline in price by 1.99%. Similarly if rates declined by 1% for each bond, the prices would be expected to rise by 8.44% and 1.99% respectively.

How much rates are expected to change is, of course, nowhere near as exact. The duration calculation is science, whereas rate forecast is art (although not always artfully made).

To take one current example, this week’s The Kiplinger Letter predicts the 10-yr Treasury rising to 4.25%. They don’t say by when, so they will definitely be exactly correct someday, but whenever they expect that to happen, that would be a 25 basis point change, upon which the duration math would suggest a 2.11% (0.25 X 8.44) decline in the price of the 10-yr Treasury.

Note that does not mean a 2.11% loss. It means a 2.11% decline in price. However, at the same time the bond is yielding 4% today, so the net of the two factors (capital loss and interest yield) is still a positive number.

If the 10-yr rate went up 50 basis points, then the capital loss would be roughly equal to one year’s interest, but if the rate never changed from there, and if you bought the bond today, you would still have a positive return (before taxes and inflation, of course), because you would continue to receive your 4% interest on cost each year, and at the end you would receive the face value of the bond.

If you needed to sell the bond on the day of the rate increase, however, you would expect to receive less by the amount of the decline caused by the product of the duration times the rate change in percent.

This chart shows the monthly price of the 10-yr Treasury (right scale — solid black line) and the monthly yield (left scale — dashed red line), which shows the inverse price and yield relationship. It also shows how rates have been rising lately, and it may give hints about where rates may go based on history.

Bond funds also have durations, typically called “average effective duration” to reflect the fact that it is collection of bonds that do not have identical yields or maturity dates. The funds also report, “average maturity”. In very general and imprecise terms, the duration of a fund indicates how much the fund may change in price if Treasury rates with a maturity approximately the same as the average maturity of the fund change by 1%.

Without going in the detail of the fund holdings, this is a very imprecise tool, but perhaps broadly useful for quick mental evaluations of interest rate sensitivity of the fund

The reason for the imprecision is the spread of durations of the individual bonds. As a simple example, if a bond fund had two bonds in it, one with a 2-yr maturity and one with a 10-yr maturity, the average maturity would be 6 years, unlike either of the bonds. Another fund might have one 5-yr bond and one 7-yr bond. It too would have an average maturity of 6 years. They would be quite different funds with a different reaction to changes in the yield curve.

Because the yield curve is in fact a curve that changes shape (most importantly steepness, from sloping up, to being flat, to sloping down), the entire yield curve generally does not do a quantum shift up or down. Instead, parts of it move more than other parts. For example, we can probably safely assume that the very short end of the curve is likely to move more in the near-term than the intermediate area.

As a consequence of the changes in the shape of the yield curve, different bonds with different maturities and yields within a fund will change in value differently. Professional bond managers would have an intimate knowledge of the composition of their portfolio and computers to aid them, with the result that they could predict changes in the value of their overall portfolio with great precision — except for the fact that they can’t predict changes in interest rates with great precision.

In any event, it is broadly useful to be aware of the duration of your bond fund holdings and to seek out reasonable predictions (or prediction ranges) for interest rates on Treasuries with maturities similar to the average maturity of your bond funds to put some kind of bracket around how much your bond fund value is likely to change in response to the interest rate changes.

If you don’t invest in bonds, this is still of value to you, because it will help you understand the thought process of bond investors and how they may move their money around, including between bonds and stocks. Money flows between asset classes are of importance to stock investors, even if they don’t invest in bonds.

The whole area is worth study. It’s not just academics.

Here are the durations for a dozen popular funds (remember – you need to look at the average maturity and the spread of maturities within the funds too):

Holdings Disclosure:
As of April 5, 2010, we hold BND, HYG, LQD, and MUB in some, but not all managed accounts, and not necessarily all in any single account. We do not have current positions in any other securities discussed in this document in any managed account.

Opinions expressed in this material and our disclosed positions are as of April 5, 2010. Our opinions and positions may change as subsequent conditions vary. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. All of our published material is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance, and there is no guarantee that any forecast will come to pass. Do not rely solely on this material when making an investment decision. Other factors may be important too. Investment involves risks of loss of capital. Consider seeking professional advice before implementing your portfolio ideas.