Duration of a bond determines the interest rate risk on it

Bond yields are in focus due to the expectations building up around a rate cut in the next monetary policy review on 4 August. For retail investors, the best way to access bond investments is through mutual funds. But before you pick a fund, you need to understand that interest-rate risk is inherent in any bond fund. This can be measured by calculating the duration, which is unique to each scheme.

What is interest rate risk?
Duration is calculated to show how long it will take for the price of a bond to be paid back through its coupon payments. For a fixed-coupon bond, the duration is always less than the maturity period. For two bonds with similar maturity, the one with a higher coupon payout will have a lower duration, as it takes a lesser time to recover its price. Bonds offer a fixed coupon, if held till maturity. However, because they are listed and traded on stock exchanges, the price of a bond can change everyday. This change, in turn, is linked to the change in yields of listed benchmark securities.

Duration determines the sensitivity of bond prices to such a change in market yields. The higher the duration of a bond, higher will be the price change when yields move. This becomes relevant when you consider that all listed bonds carry interest-rate risk, which means: fall in a bond's price when market rates rise, and increase in its price when rates fall. A five-year maturity bond for Rs.1,000, at an annual coupon of 10%, is more valuable if a year later its rates fall. All else remaining the same, a new five-year bond is likely to be issued at a lower coupon.

For an investor, the first bond becomes more valuable given its higher coupon. Demand for this bond accounts for a subsequent rise in the bond's price. Similarly, if market rates go up, the price of existing bonds falls, as the newer issuances are likely to happen at a higher coupon rate. The change in price is quantified as: duration multiplied by the change in benchmark yield.

Bond fund duration
Typically, the duration of a bond fund is the weighted-average duration of the securities held in the portfolio. The change in price of a bond fund with a high duration will be more than for one with a low duration, and the change is more or less represented as duration multiplied by the change in benchmark yield. However, the caveat here is that bond fund portfolios are dynamic and their structure matters. Moreover, the mix of corporate and government bonds also impacts the overall change in price.

Also, all income funds carry some duration risk. A simple long-term income fund and a corporate bond fund both with, say, a three-year duration, will be impacted by shifts in benchmark yield and in both cases there will be a daily change in the net asset value (NAV) to that extent. Money market funds with a maturity of 3-6 months have negligible duration risk, and change in yield only marginally impacts the NAV. For bond fund investors who aren't opportunistic in their strategy, it makes more sense to match the expected time they will remain invested, with the maturity or duration of the fund they pick.

In arrangement with HT Syndication | MINT

This article was originally published on July 28, 2016.