Duration - Full Explanation & Example | InvestingAnswers
As maturity increases, duration also increases and the bond's price becomes constant, we'll see an inverse relationship between the coupon and volatility. Nov 19, I've been talking to a lot of investors about how to prepare a portfolio for rising rates lately, and the same buzzwords keep popping up in these. Investment professionals rely on duration because it rolls up several bond characteristics (such as maturity date, coupon payments, etc.) into a single number.
Bonds issued by the U.
What’s the Difference Between Duration and Maturity?
However, Treasury bonds as well as other types of fixed income investments are sensitive to interest rate risk, which refers to the possibility that a rise in interest rates will cause the value of the bonds to decline.
Bond prices and interest rates move in opposite directions, so when interest rates fall, the value of fixed income investments rises, and when interest rates go up, bond prices fall in value.
If rates rise and you sell your bond prior to its maturity date the date on which your investment principal is scheduled to be returned to youyou could end up receiving less than what you paid for your bond.
Similarly, if you own a bond fund or bond exchange-traded fund ETFits net asset value will decline if interest rates rise. The degree to which values will fluctuate depends on several factors, including the maturity date and coupon rate on the bond or the bonds held by the fund or ETF.
Duration: Understanding the relationship between bond prices and interest rates
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. 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.
Investors will more than likely run across effective duration numbers. Despite the fancy math of the different versions, duration is more of a concept and not a tool to measure an exact expected price change of the bond when interest rates change.
Duration vs. Maturity and Why the Difference Matters
An example should drive the concept home. Keep in mind the image of a see-saw on a playground conveying the idea that when interest rates go up, bond prices go down and the opposite is true.
As noted earlier, duration is more of a concept that estimates the impact to the bond when interest rates change. Ultimately, market participants determine price, but keep in mind market participants would probably be using models to calculate duration in an attempt to determine supply selling and demand buying.
You may have noticed the duration example had the term listed as years. That is the norm used to note duration and also the probable reason why it is can be easily confused with maturity.
Recall that the formula s for duration measured how long it took for the cash flows to repay the initial investment. Now, the bottom line of the bottom line.
Two bonds may have the same maturities, but their sensitivity to interest rate changes may be different. Investors and portfolio managers not only can diversify holdings in regards to when the holdings may expire or mature, but now can diversify holdings in regards to the possible volatility or impacts to bond price movements as interest rates change.
Take high yield bonds for example — according to the iShares website www. The bonds within these portfolios have, on average, a relatively similar period of time until the principal is assumed to be paid as shown by the average maturities.
However, high yield bonds are implied to have greater insulation to changes in interest rates versus the year Treasuries. Effective Duration Effective duration refers to the expected decline in a bond's price in response to an increase in its yield.
What’s the Difference Between Duration and Maturity? | BlackRock Blog
While the price of a bond will decline as its yield goes up, regardless of the bond's maturity or coupon, the extent of this decline varies greatly. Effective duration measures how many percentage points the price of the bond will decline if the yield advances by 1 percent.
Effective duration is related to the maturity of the bond. The longer the bond's maturity, the greater its duration. However, the duration is always a smaller number than the maturity. If a bond has 10 years to maturity, its duration may be six or seven, for example, but it will not be Average Duration vs Maturity The average maturity of a bond portfolio equals the weighted average maturities of all the bonds in it.