The sensitivity of a bond’s market price to changes in interest rates is described as volatility. Given a change in interest rates, some bonds will show greater volatility than others. Using Duration provides an objective measure by which to compare the expected volatility of different bonds or bond funds.
The Duration calculations take into account bond coupons as well as maturities; thus duration is a better indicator of a bond’s expected market price volatility (as yields change) than maturity or “priced-to-date” alone. There are two different calculations for duration:
- Macaulay Duration is the average weighted maturity of the present values of a security’s cash flows. Quoted in years, this calculation is now rarely used. Macaulay Duration can be helpful to rank bonds based on relative volatility, but is less helpful in understanding the impact of interest rate changes on a bond or a portfolio.
- Modified Duration is the estimated percentage change of the price of a security for an immediate 1% change in yield and is the calculation most commonly used by professional portfolio managers. A bond (or mutual fund, closed end fund or ETF) with a Modified Duration of 5.0 would be expected to decline in market value by 5% if rates immediately moved higher by 1%. The reverse would also be true—if rates decline by 1%, then that hypothetical bond (or fund) would be expected to move higher in value by 5%.
With both calculations, the larger the number, the greater the expected change in market price when rates move. (For the rest of this article, and as is standard in the industry, Duration will refer to Modified Duration.)
To calculate the Duration for a portfolio (or a fund), the Duration for each of the individual bonds in the portfolio is calculated, and then weighted to come up with the Duration for the overall portfolio.
The appropriate “target” Duration can vary from one investor to the next, and should be revisited if there is a meaningful change in your situation or in market conditions.
- Investors expecting rates to decline may want to maximize the opportunity for price appreciation by favoring bonds or funds with a higher Duration.
- Investors anticipating an increase in rates and who want to avoid volatility may prefer a lower Duration.
However, if your financial plan provides a recommended asset allocation mix, compare the Duration of the fixed-income benchmark used against your portfolio. Using a lower-Duration target than the benchmark may require a higher fixed income allocation to achieve the desired diversification. Conversely, using a higher target Duration may permit a reduction in the percentage allocated to fixed income.
Because it is only an estimate of the change in market price, using Duration as a guide to volatility has its limitations. Changes in prevailing market conditions will affect the actual price movement of individual bonds differently. However, Duration is an excellent tool for comparing different bonds or portfolios.
Modified Duration for a bond can be calculated in Microsoft Excel using the MDURATION function.
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This is not investment advice. This information is presented for informational purposes only. Any determination as to what bonds or strategy may be appropriate for you should reflect your own objectives and risk tolerance. The opinions expressed and the information contained herein is based on sources believed to be reliable, but its accuracy and appropriateness is not guaranteed. Past performance is interesting but is not a guarantee of future results. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Investments in bonds and fixed-income investments are subject to gains/losses based on the level of interest rates, market conditions and changes in credit quality of bond issuers. Additional information available upon request.
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