How to Make Buying Bonds Easier, Safer and More Rewarding
Let's say you wake up one fine day with an urge to buy a bond or a bond mutual fund. It could happen to you for any number of reasons. And whatever the reason you want a bond, being a diligent investor, you look at all the things you are supposed to: yield, maturity, and credit rating.
But if you don't examine the bond's duration, you could be in for a nasty surprise. Understanding duration can make buying bonds safer, saner, and more rewarding - whether you buy individual issues or a bond mutual fund.
Pure and simple, duration tries to estimate the potential price volatility of a bond due to a change in interest rates. It would be the equivalent to what stock market investors try to estimate with beta. So just as beta measures the price volatility of one stock compared with another, duration compares how much one bond is likely to move in price versus another, as interest rates change. The two concepts differ in that a stock's beta is based on past performance, while duration is based on what will happen in the future.
Specifically, duration seeks to measure how long it will take, through the combination of interest and principal payments, before you recoup the money you invested in the bond. The longer the duration, which is another way of saying the longer your money is at risk, the more volatility you must expect along the way. The shorter the duration, or the quicker you get your money back, the less volatility you can expect.
Volatility isn't bad per se. High volatility means bigger losses when interest rates rise and prices fall, but bigger profits when the opposite occurs. Low volatility limits losses, but also dampens potential gains. It's your choice, but you want to know what you're getting before you buy.
Why, you might ask, do you need to worry about duration at all? Why not just concentrate on the bond's maturity date? The maturity date, after all, tells you when the repayment of principal will eliminate all risk. If it's a 20-year $1,000 bond, you will get your $1,000 back in 20 years, after which your risk of losing money is zero.
The trouble is, by using maturity alone, you are saying a 20-year bond is a 20-year bond is a 20-year bond, whether it is a U.S. Treasury issue, a junk bond, or a zero-coupon bond. Common sense tells you that can't be the case. A junk bond and a zero-coupon bond can't behave the same way even if they have the same maturity. Some other measure must differentiate bonds in the eyes of investors. That's where duration comes into the picture.
Duration's key measure is the cash flow the bond throws off, year after year, until it matures. Here's how it works.
Say you pay $1,000 for a 12%, 20-year junk bond from XYZ Corporation. On day one, you have $1,000 at risk. In six months time, you'll get a $60 semi-annual interest payment. Now $60 of the $1,000 you put at risk has been repaid. Each incremental interest payment further reduces the amount you have at risk. After 8-1/2 years, you will have received $1,020 in interest, which is more than the $1,000 you invested originally. Thus the maturity of the bond may be 20 years, but the duration is about 8-1/2 years.
Now compare that 12%, 20-year junk bond with a 20-year zero-coupon bond, bought at a discount and paying nothing until it matures. Because there is no cash flow from the zero, its maturity and its duration are both the same: 20 years. The junk bond throws off lots of cash, which reduced its duration to 8-1/2 years. Since the potential for price volatility increases with a bond's duration, the zero-coupon figures to be more than twice as volatile as the coupon issue.
That may come as a shock if you have socked away zero-coupon bonds to pay college bills on the assumption that zeros are the most stable things around. They are stable, if you can hold out until the zero pays off. But if you find it necessary to sell before maturity, you could be in for a rude awakening.
A zero-coupon bond is far and away the riskiest security an investor can own, because its duration is very long. A 100-basis-point [one percentage point] rise in rates on a 20-year zero will chop off about 20% of the value of that security. That's a huge change in the price of a security with a fairly small overall change in interest rates.
Obviously, that makes the zero-coupon bond volatile. But how volatile is volatile? That's easy to figure out.
Duration, multiplied by the change in interest rates, equals change in price.
Let's say that a bond mutual fund has a five-year duration. Then, if interest rates rise two percentage points, that's going to mean a 10% loss in the price of this fund. That's the strategic view of duration.
So what are the tactics to be used when buying individual bonds or bond funds?
You want a bond's duration, and its accompanying price volatility, or lack thereof, working for you. The more you believe that interest rates are heading lower, the longer the duration you want. The more you believe that interest rates are heading higher, the shorter the duration you want.
Two things happen with a long-duration bond when interest rates fall, both of them good:
The longer the duration, the more time before you must reinvest your money at lower interest rates. And the more the price of your bonds will climb as interest rates fall. As an example of how this works, let's say your bond has a five-year duration. Each 1% drop in interest rates means a 5% gain in the bond's price. That price gain jumps to 15% if the bond has a 15-year duration.
If you think rates are heading higher, then you want to buy short-duration issues, since the value of long-duration bonds plummets when rates rise. A 1% rise in rates will knock 15% off the price of a bond with a 15-year duration. The same increase will knock only 2% off a security with a two-year duration. The shorter the maturity, the narrower the gap between maturity and duration. That makes sense given the formula: Change in interest rates multiplied by the duration equals change in price.
When in doubt about rates, pick duration securities that are more in the middle of the road. That gives you a strategy to use through both the bull and bear phases of the market.
If you are going to use duration as a buying tool - a way to eliminate the risk of rising interest rates on bonds - then there are three things to keep in mind.
First, you must make your own interest rate forecast. Duration can only tell what will happen to the price of a given bond if interest rates move as you expect them to.
Second, the duration figure may not always be readily available. If you buy an individual bond, your broker should be able to tell you its duration. But in the case of a bond mutual fund, there is at best a 50-50 chance of learning the duration of the portfolio of bonds in any mutual fund, so you really should never invest in any bond mutual fund unless you can know with certainty the bond fund's duration.
Thirdly, remember there are many ways of measuring duration. Do you count duration to final maturity, or to first call date, or what? However you choose to measure duration, it's important to use the same method of calculating duration when comparing one investment with another.
Duration isn't perfect, but then you wouldn't buy a stock based solely on its beta. But duration is one more tool for making wise fixed-income investments.
NOTE: Be sure to also check in our "Archive" for my January 12, 2005 posting titled, "Getting Good Bond Prices" - which can save you from making a very expensive mistake when buying individual bonds.
* * * * *
But if you don't examine the bond's duration, you could be in for a nasty surprise. Understanding duration can make buying bonds safer, saner, and more rewarding - whether you buy individual issues or a bond mutual fund.
Pure and simple, duration tries to estimate the potential price volatility of a bond due to a change in interest rates. It would be the equivalent to what stock market investors try to estimate with beta. So just as beta measures the price volatility of one stock compared with another, duration compares how much one bond is likely to move in price versus another, as interest rates change. The two concepts differ in that a stock's beta is based on past performance, while duration is based on what will happen in the future.
Specifically, duration seeks to measure how long it will take, through the combination of interest and principal payments, before you recoup the money you invested in the bond. The longer the duration, which is another way of saying the longer your money is at risk, the more volatility you must expect along the way. The shorter the duration, or the quicker you get your money back, the less volatility you can expect.
Volatility isn't bad per se. High volatility means bigger losses when interest rates rise and prices fall, but bigger profits when the opposite occurs. Low volatility limits losses, but also dampens potential gains. It's your choice, but you want to know what you're getting before you buy.
Why, you might ask, do you need to worry about duration at all? Why not just concentrate on the bond's maturity date? The maturity date, after all, tells you when the repayment of principal will eliminate all risk. If it's a 20-year $1,000 bond, you will get your $1,000 back in 20 years, after which your risk of losing money is zero.
The trouble is, by using maturity alone, you are saying a 20-year bond is a 20-year bond is a 20-year bond, whether it is a U.S. Treasury issue, a junk bond, or a zero-coupon bond. Common sense tells you that can't be the case. A junk bond and a zero-coupon bond can't behave the same way even if they have the same maturity. Some other measure must differentiate bonds in the eyes of investors. That's where duration comes into the picture.
Duration's key measure is the cash flow the bond throws off, year after year, until it matures. Here's how it works.
Say you pay $1,000 for a 12%, 20-year junk bond from XYZ Corporation. On day one, you have $1,000 at risk. In six months time, you'll get a $60 semi-annual interest payment. Now $60 of the $1,000 you put at risk has been repaid. Each incremental interest payment further reduces the amount you have at risk. After 8-1/2 years, you will have received $1,020 in interest, which is more than the $1,000 you invested originally. Thus the maturity of the bond may be 20 years, but the duration is about 8-1/2 years.
Now compare that 12%, 20-year junk bond with a 20-year zero-coupon bond, bought at a discount and paying nothing until it matures. Because there is no cash flow from the zero, its maturity and its duration are both the same: 20 years. The junk bond throws off lots of cash, which reduced its duration to 8-1/2 years. Since the potential for price volatility increases with a bond's duration, the zero-coupon figures to be more than twice as volatile as the coupon issue.
That may come as a shock if you have socked away zero-coupon bonds to pay college bills on the assumption that zeros are the most stable things around. They are stable, if you can hold out until the zero pays off. But if you find it necessary to sell before maturity, you could be in for a rude awakening.
A zero-coupon bond is far and away the riskiest security an investor can own, because its duration is very long. A 100-basis-point [one percentage point] rise in rates on a 20-year zero will chop off about 20% of the value of that security. That's a huge change in the price of a security with a fairly small overall change in interest rates.
Obviously, that makes the zero-coupon bond volatile. But how volatile is volatile? That's easy to figure out.
Duration, multiplied by the change in interest rates, equals change in price.
Let's say that a bond mutual fund has a five-year duration. Then, if interest rates rise two percentage points, that's going to mean a 10% loss in the price of this fund. That's the strategic view of duration.
So what are the tactics to be used when buying individual bonds or bond funds?
You want a bond's duration, and its accompanying price volatility, or lack thereof, working for you. The more you believe that interest rates are heading lower, the longer the duration you want. The more you believe that interest rates are heading higher, the shorter the duration you want.
Two things happen with a long-duration bond when interest rates fall, both of them good:
The longer the duration, the more time before you must reinvest your money at lower interest rates. And the more the price of your bonds will climb as interest rates fall. As an example of how this works, let's say your bond has a five-year duration. Each 1% drop in interest rates means a 5% gain in the bond's price. That price gain jumps to 15% if the bond has a 15-year duration.
If you think rates are heading higher, then you want to buy short-duration issues, since the value of long-duration bonds plummets when rates rise. A 1% rise in rates will knock 15% off the price of a bond with a 15-year duration. The same increase will knock only 2% off a security with a two-year duration. The shorter the maturity, the narrower the gap between maturity and duration. That makes sense given the formula: Change in interest rates multiplied by the duration equals change in price.
When in doubt about rates, pick duration securities that are more in the middle of the road. That gives you a strategy to use through both the bull and bear phases of the market.
If you are going to use duration as a buying tool - a way to eliminate the risk of rising interest rates on bonds - then there are three things to keep in mind.
First, you must make your own interest rate forecast. Duration can only tell what will happen to the price of a given bond if interest rates move as you expect them to.
Second, the duration figure may not always be readily available. If you buy an individual bond, your broker should be able to tell you its duration. But in the case of a bond mutual fund, there is at best a 50-50 chance of learning the duration of the portfolio of bonds in any mutual fund, so you really should never invest in any bond mutual fund unless you can know with certainty the bond fund's duration.
Thirdly, remember there are many ways of measuring duration. Do you count duration to final maturity, or to first call date, or what? However you choose to measure duration, it's important to use the same method of calculating duration when comparing one investment with another.
Duration isn't perfect, but then you wouldn't buy a stock based solely on its beta. But duration is one more tool for making wise fixed-income investments.
NOTE: Be sure to also check in our "Archive" for my January 12, 2005 posting titled, "Getting Good Bond Prices" - which can save you from making a very expensive mistake when buying individual bonds.
* * * * *
posted by Bob Moser at
7:14 PM
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