What is Duration?
TOM BUTCHER: Thank you for joining me today. Can you explain duration?
FRAN RODILOSSO: Duration is an attempt to measure a bond or a bond portfolio's sensitivity to movements in interest rates. It’s one way of assessing the risk of a bond or portfolio of bonds. Mathematically, the original duration measurement is a weighted average of the time to maturity of all of a bond's cash flows: its coupons, as well as its principal repayments.
There have been various refinements to the duration measurements and there are a number of different durations used. When an analyst today talks about a bond or a portfolio's duration, he or she is usually talking about modified or effective duration, which measures a bond's price sensitivity to movement in yield. More technically, if a bond has a duration of 5, it suggests that the bond's price would change 5% when there is a 1% change in yields. If a bond yield goes from 3% to 4%, one would expect that bond to lose about 5% in price.
BUTCHER: Is duration a precise science?
RODILOSSO: Duration measurements are precise in how they are calculated. That is, however, a very good question, because duration has some pitfalls. It is really a more accurate measurement over very small movements in yield. The price-yield relationship of a bond is not a straight line; it's a curve. Mathematically, what the modified duration calculation represents is the slope of that curve at the bond's yield today. Because a curve does not have a constant slope and because as the yield moves the slope changes, duration changes as well. Duration is therefore a more precise measure over very small changes in yield. With respect to bonds with embedded options, i.e., bonds with calls or puts or mortgage-backed securities with all sorts of potential prepayment streams, duration calculations are less effective.
Finally, duration assumes that the shift in the yield curve, i.e., the movement in interest rates, is done in a parallel fashion throughout the yield curve.
BUTCHER: Is there only one way to calculate duration?
RODILOSSO: There are a variety of duration calculations. When most bond analysts refer to duration, they’re usually talking about modified duration or effective duration, which attempt to capture the sensitivity of a bond's price to its yield. The original duration measurement, however, is simply a weighted average of time to maturity that is expressed in years. Macaulay duration, for instance, is expressed in years. Other types of duration are expressed in units, e.g., a bond may have a duration of 5.0, which usually refers to modified duration. Again, when it comes to bonds with options, a different measurement is required; effective duration, for instance, measures a bond's price movement over larger interest rate movements.
BUTCHER: Why exactly does duration matter?
RODILOSSO: Duration is a good way to measure a bond’s risk in response to movements in interest rates or movements in its own yield. It’s very important, however, to remember several factors. Duration is not a constant number. It changes as a bond's price and yield change.
Additionally, there are many other risks involved in investing in a bond or portfolio of bonds. If you are invested in U.S. Treasuries, duration is your main concern because your main risk is interest rate risk. If you're invested in a portfolio of high-yield bonds, credit risk is probably a more significant risk by a wide margin over interest rate risk; this has been proven over time. In fact, high-yield bonds often show a negative correlation with Treasuries in response to interest rate movements.
There are other types of risk as well. There is liquidity risk. There's also the fact that not all interest rate movements or yield curve movements are parallel. When they're not parallel, the duration measurement may not be as accurate in terms of measuring sensitivity of bond price to movements in yield.
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