Back in 1938, the concept of bond duration was first introduced by Canadian economist, Frederick Macaulay. Macaulay duration is defined as the weighted average of the time until the fixed cash flows from an asset are received. It is frequently reformulated as modified duration to change the units from time to a more useful figure measuring the price sensitivity of a bond with respect to yield.
Bond prices and interest rates are inversely related. Like a teeter totter, if one goes up the other goes down. So when rates fall, bonds rise and when rates rise as has generally been the recent trend, bonds fall. Modified duration approximates the degree of the corresponding change in a bond’s price due to a 1% change in interest rates.
For example, if you hold a bond or bond fund with a modified duration of 6, a 1% change in interest rates will result in an approximate 6% change in the price of the bond fund. If rates fall by 1%, this bond will rise by approximately 6% and if rates rise by 1% this bond will fall by approximately 6%. In addition to the credit quality and corresponding credit risk of a bond, interest rate risk is a critically important aspect of analyzing your bond holdings and is best understood through duration.
Even if rising rates remain a headwind for bond prices, bonds still remain a key component of most portfolios due to their steady stream of income payments and lack of correlation with the equity markets. Buying and holding individual bonds to maturity can help manage interest rate risk. The bond’s price will be subject to interim price fluctuations due to changing interest rates, but upon maturity, assuming no credit issues, you will receive back the bond’s full par value.
It is a good time to review and understand how much interest rate risk is in your portfolio to ensure it is appropriate given your investment objectives and time horizon. Should rates continue to trend higher, investors may consider reducing duration or buying and holding individual bonds to their maturity dates. Both will help mitigate interest rate risk and likely improve your investment portfolio in a rising rate environment.
