Rising interest rates can have an effect on bond values. After all, if you’re holding a bond paying 2% and interest rates for comparable bonds rise to 3%, you’ll have trouble finding a buyer unless you’re willing to reduce the price of the bond to make up the difference.
In addition, a bond paying 2% for the next thirty years will be harder to sell than one that has only one year left. This means that, generally speaking, the longer the maturity the more the price will be affected by rising rates.
But, maturity measures only the time until principal is due – it doesn’t consider the coupon payments. Duration is a measure that incorporates both the magnitude of the principal and interest payments and the timing of those payments, as well. Think of duration as the weighted average time to receipt of both coupon and principal payments. For those of you familiar with time-value-of-money, the weights are the present value of each cash flow.
If you own bond funds, you can often find duration figures for the funds you own from a variety of commercially-available sources; and, that’s the data that will help you determine how much your bond values are likely to change in response to interest rate movements. Today, duration is expressed as modified duration (a math adjustment to more accurately reflect interest rate sensitivity).
Without getting too deep into the weeds of bond math, this formula will help you determine what price changes you can expect with a change of interest rates:
Price Change = (Duration) x ( – Yield Change)
For example, if you find your bond portfolio has a modified duration of 7.4 and market interest rose by 0.50% per year, the bond portfolio value could be expected to decline to around 3.7%. By the same token, if interest rates fell by 0.50%, you could expect the bond portfolio to add 3.7%. The higher the duration, the higher the interest rate sensitivity.\
There are some limitations you should be aware of:
- Duration is useful over only a limited range of yield change
- Price changes due to changes in bond quality or changes in sectors aren’t considered
- Duration assumes the shape of the yield curves will remain unchanged – in the real world, they do change.
There’s more to know, of course. Talk to your advisor.
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Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located across the U.S.. He is also licensed for insurance as an independent agent under California license 0C00742. IFG helps specializes in crafting wealth design strategies around life goals by using a proven planning process coupled with a cost-conscious objective and non-conflicted risk management philosophy.
The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.