Today I want to take a step back from the markets and talk about one of the fundamental concepts in fixed income investing: interest rate sensitivity. Namely, what happens to the price of a bond or bond fund when interest rates move? This has been a hot topic recently as interest rates have fallen to near record lows and bonds in general have performed well. Investors want to understand what might happen if the trend reverses and rates rise. They are asking: “Will my bond investment fall in value and, if so, buy how much?”
To start, let’s illustrate why you care if interest rates move. Let’s say that an investor pays $100 to buy $100 par of a 3% bond that matures in 6 years. The bond will pay the investor $3 per year in interest, and at the end of 6 years, the investor will get the initial $100 investment back. Simple enough. Now, let’s say that interest rates rise to 4%. Naturally our investor isn’t going to feel as good about their 3% bond because they could now pay $100 to buy a new 4% bond. Their 3% bond isn’t worth $100 anymore, but just how much is it worth? Luckily, there is a handy way to measure how interest-rate sensitive the bond is and by how much its price would change as rates rise. It’s called duration.
Duration is stated in years, and it’s meant to help predict the likely change in the price of a bond given a change in rates. Generally, for every 1 percentage point increase or decrease in interest rates, a bond’s price will change roughly 1 percent in the opposite direction for each year of duration. Let’s say the duration of our example bond is 5 years. This chart shows how changes in rates would affect the bond’s price:
In our example, the increase in rates from 3% to 4% was 1 percentage point, which would result in a -5% change in the bond’s price (5 (years) × 1%). The price would fall to $95 from $100.
Duration can be used for both bonds and bond funds. Using iShares ETFs as an example, the 1.84 year duration of the iShares 1-3 Year Treasury Bond Fund (NYSEARCA:SHY) means that we can generally expect SHY’s price to decline by 1.84% if interest rates rise by 1 percentage point. By comparison the iShares 20+ Treasury Bond Fund (NYSEARCA:TLT) has a much longer duration of 17.15, meaning that we could generally expect its price to decline 17.15% if interest rates rose by 1 percentage point.
To be fair, duration by itself doesn’t perfectly capture bond price sensitivity. There are other things to consider such as convexity and curve movements. But duration explains the majority of price movement for most bond investments, and so it is a handy way to measure interest rate sensitivity.
By understanding duration investors can structure their portfolio to meet their overall investment objectives and risk tolerance. For investors who are worried that rates might rise, short-duration investments will have lower interest rate sensitivity than longer-term funds.