How Does Duration Impact Bond Funds?
Bond duration is an investment concept that few average investors truly understand, yet it can have a meaningful impact on how your bond mutual fund or fixed income portfolio performs relative to the bond market as a whole. Investors tend to shy away from discussions of bond duration because the underlying math is relatively difficult. The good news is that once you look past the math involved, the underlying concept of duration is easily understood. And to make good use of duration when investing in bonds, you don't need to calculate it – you just need to understand the concept.
However, before discussing duration further, consider another bond term related to duration: present value.
What Is Present Value?
Present value is what an investment is worth at the moment of evaluation. It contrasts with the value that the investment may have at some future time after it has benefited from compound interest. It acknowledges that investors discount the future value of an investment. Although ten years from now a sum invested at 6 percent compounded annually will be worth much more than the initial investment, investors place a discount on money earned in the future. The basic idea is that money received next year is worth less than money in hand now and money earned the year after that is worth even less.
Which would you prefer: $100 in your pocket now or the promise of $100 you'll receive in three years?
In assessing how much future cash is worth, investors use a “discount rate” – typically prevailing interest rates. In a series of cash flows – such as investors receive from a bond – this allows the investor to place a value on each cash payment he or she receives. The higher the discount rate, the less the future cash flows are worth. The lower the discount rate, the greater their value.
What Is Duration?
For individual investors, the duration is primarily used as a measure of a bond fund’s sensitivity to prevailing interest rates. It's defined as the weighted average of the payments an investor will receive over time, discounted to the bond's present value.
Duration, which is expressed in years, measures how much a bond's price will rise or fall when interest rates change. The longer the duration, the greater the bond's sensitivity to interest rate changes. From this, you can conclude, all else being equal, that immediately after you purchase a 30-year bond, its duration is greatest, and as the bond approaches maturity its duration falls. Similarly, shorter-term bonds have an initial duration – sensitivity to interest rate changes – that is less than the initial duration of longer-term bonds.
Duration, then, is a particular expression of volatility.
The Impact of Duration on Bond Funds
Duration, which is expressed in years, is a term that investors will encounter when assessing mutual fund investments. Typically, fund managers will say their portfolio is “overweight” or “long” duration, meaning that their duration is higher than that of the fund's benchmark. Alternatively, the portfolio could be “underweight” or “short” duration.
Duration impacts the relative performance of the bond funds or a portfolio of individual bonds. A portfolio with a duration that is above its benchmark can be expected to outperform the benchmark if rates are falling, and underperform if rates are rising. Conversely, a portfolio with a below-benchmark duration will typically outperform when rates are rising, and underperform when rates are falling. Again, this is a particular measure of volatility and, hence, of risk, but not the only one.
Other factors also impact portfolio performance; most notably, the specific market segments in which it is invested – durations of junk bond funds will exceed durations of treasury funds with similar maturities. Note as well, that duration should be considered a snapshot rather than a permanent aspect of the fund’s strategy. For managers of actively-managed funds, the duration is a moving target. Some managers will actively shift their portfolios around the benchmark target in response to market developments.
Developments in the market. As a result, any duration number from a dated source – such as a Morningstar report or a fund’s annual report – should be considered a snapshot rather than a permanent aspect of the fund’s strategy.
The exception is when a fund has a specific mandate to invest with a particular positioning. For example, many mutual funds and exchange-traded funds contain “Long Duration” or “Short Duration” in their titles. Investors, therefore, need to be alert to the risk/reward trade-offs of such funds rather than simply using their past performance as a gauge of quality. “Short duration” funds can generally be expected to be lower risk / lower yield, while longer duration funds tend to feature higher risk and higher yields.
For investors, the takeaway is that duration – while just one of many factors that can impact the performance of a fixed-income portfolio – is something that nonetheless warrants attention since it is one of the most important factors in the risk profile of any bond investment you might consider.