Interest rates are currently hovering near historic lows. Numerous economists believe that interest rates are not likely to get much lower and will eventually rise. If that notion is true, then outstanding bonds, particularly those with a low interest rate and high duration may experience significant price drops as interest rates rise. If you are a bond or bond fund investor, you should be familiar with "duration." Although stated in years, duration is not simply a measure of time. Instead, duration indicates how much the price of your bond investment is likely to fluctuate when interest rates rise or decline. The higher the duration number, the more sensitive your bond investment will be to changes in interest rates.
Duration risk is associated with the sensitivity of a bond's price to a one percent change in interest rates. The higher a bond's duration, the greater its sensitivity to interest rates changes. 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. Duration has the same effect on bond funds. For example, a bond fund with 10-year duration will decrease in value by 10 percent if interest rates rise one percent. On the other hand, the bond fund will increase in value by 10 percent if interest rates fall one percent. If a fund's duration is two years, then a one percent rise in interest rates will result in a two percent decline in the bond fund's value. A two percent increase in the bond's fund value would follow if interest rates fall by one percent.
Once you know a bond's or bond fund's duration, you can predict how it will react to a change in interest rates. Keep in mind that just because a bond or bond fund's duration is low, it does not mean your investment is risk-free. In addition to duration risk, bonds and bond funds are subject to inflation risk, call risk, default risk, and other risk factors. These factors will be discussed in a bond's offering document or a bond fund's prospectus.
Did your broker sell you long-term bonds or a bond fund that holds primarily long-term bonds without disclosing duration risk as well as all the other risks associated with fixed income investing?
The most important of investors' rights is the right to be informed! This Investors' Rights blog post is by the Law Offices of Robert Wayne Pearce, P.A., located in Boca Raton, Florida. Please see our Instablog profile (left column) for ways to contact us and get answers to any of your questions about this blog post and/or any related matter.