Fixed Income 101: Duration
Duration measures the sensitivity of a bond’s price to changes in its yield. A bond’s price and its yield have an inverse relationship: when its price rises, its yield falls, and when price falls, its yield rises. For example, for a bond with a five-year duration, a 1% rise in yield would typically lead to an approximate 5% fall in price, as the change in yield can be multiplied by the bond’s duration.
For an individual bond, duration refers specifically to changes in its yield. Bond yields can move because of changes in underlying interest rates, or because investors demand greater compensation for the bonds they hold, for example, if an issuer’s credit quality changes.
At the portfolio level, duration is generally discussed in terms of sensitivity to market-wide impacts such as changes in interest rates or the sort of broad credit spread widening that occurs when investors become more worried about the risk of recession.
Duration versus maturity
The maturity of a bond is when a bond’s principal is due to be repaid. For example, if Alphabet issues a $500m five-year bond, investors will receive the principal back in exactly five years, if the payment schedule is maintained. Duration, by contrast, measures the weighted average time in years it takes for a bondholder to receive all that bond’s cashflows, including both the coupons and the principal repayment.
Generally, the longer a bond’s maturity, the longer its duration is likely to be. However, duration is often lower than the stated maturity on a bond as investors receive coupon payments before the principal is repaid. A 10-year bond paying a 5% coupon, for example, would have a duration of just under eight years. The main exception to this is for a zero-coupon bond, where maturity is the same as the bond’s duration.
Why longer duration bonds are more sensitive to yield moves
Exhibit 1 highlights how bonds with longer duration are more sensitive to moves in yield than those with shorter duration. At the very long end of the curve, where bonds may have maturities of 30 years or more, this would imply a much larger fall in cash price.
However, this assumes the relationship between a bond’s price and yield is linear (it isn’t), which is where convexity comes in.
Why convexity matters
Convexity captures the curvature of the relationship between a bond’s yield and its price, which matters because duration is only an approximation. When its yield falls, a bond with higher convexity may see its price rise by more than its duration would imply. The reverse is also true: when its yield rises, the price may fall by less than its duration predicts. For fixed income investors, this can make higher convexity attractive: it may offer an additional buffer if the yield rises, while allowing investors to capture more of the price gains if it falls.
Exhibit 2 highlights the difference between the price movement estimated by duration and the actual price move, with Bond B having higher convexity than Bond A. The shaded green area shows that when a bond’s yield falls, the price rise may be greater than duration would estimate. This is because the relationship between a bond’s price and its yield is curved rather than linear. Therefore, convexity shows that the greater the change in a bond’s yield, the harder it is to predict the subsequent change in its price.
Key drivers of duration
Several factors affect a bond’s duration, including its maturity, coupon, and yield.
Longer maturity bonds typically have higher duration, for example, as a greater percentage of their present value depends on future cashflows. Simply put, the more a bond’s value depends on future payments, the greater the impact on its price when interest rates move.
Generally, the larger a bond’s coupon, the lower its duration, because investors receive a greater share of the bond’s cashflows before maturity. Lower coupon bonds usually have higher duration because the principal payment at maturity accounts for a higher percentage of the bond’s total present value.
A higher yield, meanwhile, is associated with lower duration as future cashflows are discounted more heavily and therefore represent a lower proportion of the bond’s present value, making the bond’s price less sensitive to changes in yield.
Interest rate duration and credit spread duration
Investors may also want to differentiate between interest rate duration and credit spread duration. A bond’s yield can move because of changes in interest rates or a shift in the issuer’s credit spread (the additional yield investors demand for holding a corporate bond, for example, over a reference “risk-free” government bond). These can happen simultaneously or separately, and both can affect a bond’s price.
The distinction is key for securitisations such as asset-backed securities (ABS) and collateralised loan obligations (CLOs). These securities typically have structurally lower interest rate duration than traditional corporate bonds because the majority are floating rate, with coupons that reset as the benchmark rate moves. This reduces their sensitivity to changes in underlying interest rates.
However, this does not mean ABS products are completely immunised from duration risk, as they still have credit spread duration. If investors become increasingly concerned about the risk of default on a security, its credit spread is likely to widen. This increases the yield investors demand, causing the bond’s price to fall. Therefore, the greater the credit spread duration of a bond, the larger that price impact is likely to be.
Why headline duration does not tell the full story
While duration measures a fund’s sensitivity to changes in yield, it is just one number and will not tell you everything about a portfolio. For example, two portfolios might have an equal duration of four years, but one may be concentrated around the four-year point while the other combines exposure to both short and long duration bonds for an average of four years.
This is important because short-dated bonds tend to be highly influenced by near-term rate expectations. Longer dated bonds can be more sensitive to changes in growth, inflation, fiscal policy and term premium because their cashflows are paid further into the future, making their prices more vulnerable to changes in the macro outlook. Therefore, investors should consider not just the headline duration figure, but also how a portfolio’s holdings are distributed along the curve, as two portfolios with near-identical duration can have very different sensitivities.
A further nuance is that even if there is a parallel shift in yields across the curve, spreads may not move equally. BB rated issuers for example may see their spreads widen significantly more than higher-rated securities. Duration measures price sensitivity to a given move in yields, but it may not always clearly show the severity of that move. As a result, portfolio managers must consider duration alongside a combination of relevant factors, such as size, credit quality and sector.
Why portfolio managers may extend duration
For portfolio managers, extending duration increases exposure to moves in rates and credit spreads. As a result, they need to determine whether they are being adequately compensated for the additional beta they are taking on.
If a portfolio manager has confidence in the market and is bullish about the macro outlook, they may look to extend duration. This can offer upside if interest rates fall or credit spreads tighten. However, it can also increase downside risk if conditions deteriorate and there is a sell-off in bonds and yields rise, particularly at the longer end of the curve.
A manager does not exclusively need to hold a positive macro view to extend duration. If a portfolio manager is credit spread neutral, but expects a rally in government bonds, they might opt to extend interest rate duration and increase the portfolio’s sensitivity to a fall in underlying interest rates while keeping the portfolio’s overall credit spread exposure broadly unchanged. This would make the decision a rates-based one, anticipating a flattening of the yield curve rather than reflecting a credit view.
A manager may also choose to extend portfolio duration to take advantage of steepness in the yield curve without expecting any change to longer dated yields. In this instance, the portfolio manager is capturing the additional yield on offer from longer dated bonds as well as the potential capital gains associated with roll-down as those bonds become shorter dated over time.
Duration can work as a form of risk management, enabling managers to adjust a portfolio’s sensitivity to changes in underlying interest rates and credit spreads.
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