Duration is a commonly used term in fixed income and it refers to the price sensitivity of a bond for a unit change in yield. In other words, a bond with duration of 7 will decline by 7% as yields move up by 1%. Typically, duration is calculated as the length of time it takes in years for the bond price to be repaid by its internal cash flows.
What Affects Duration?
Duration is affected by three factors – coupon of the bond, its term and yields. The coupon is a periodic payment to the bond holder; it can be monthly, quarterly or semi-annual depending on the agreement. The term is how long the bond is issued for; the period after a certain number of years the bond issuer has to pay back the bond holder. Yield is the interest rate on the bond. A bond with a high coupon is paid faster than one with a low coupon resulting in lower duration. The longer the term of the bond or years to maturity implies higher duration. Higher yields means the cash flows from the bond are invested at higher rates, which reduces the duration of the bond. A bond with high duration carries higher risk because it has more price volatility to changes in interest rates. There are several types of duration measures such as Macaulay duration, modified duration, effective duration, and key rate duration. The most common measure is modified duration. It is calculated as the present value of all cash flows adjusted by the yield of the bond.
Significance of Duration In Portfolio Management
Portfolio Managers monitor the duration of their accounts closely as wild swings in interest rates would impact their portfolios. Bond managers can achieve their target duration by mimicking their index with short, mid, and long term bonds. They can also utilize a barbell method with short and long duration bonds or bullet method with heavy concentration in mid bonds maturing around the same target time period or a laddering method with bond maturities spread out relatively evenly across several years while achieving the target duration. While duration would be the same in all three cases, returns would be different because of movement in interest rates for the different terms.