Advanced Bond Concepts: Duration
Understanding what duration is, how it is used and what factors affect it will help you to determine a bond’s price volatility. Volatility is an important factor in determining your strategy for capitalizing on interest rate movements. Furthermore, duration will also help you to determine how you can protect your portfolio from interest rate risk.
For each of the two basic types of bonds the duration is the following:
1. Zero-Coupon Bond – Duration is equal to its time to maturity.
2. Vanilla Bond – Duration will always be less than its time to maturity.
Let’s first work through some visual models that demonstrate the properties of duration for a zero-coupon bond and a vanilla bond.
Duration of a Zero-Coupon Bond
The red lever above represents the four-year time period it takes for a zero-coupon bond to mature. The money bag balancing on the far right represents the future value of the bond, the amount that will be paid to the bondholder at maturity. The fulcrum, or the point holding the lever, represents duration, which must be positioned where the red lever is balanced. The fulcrum balances the red lever at the point on the time line at which the amount paid for the bond and the cash flow received from the bond are equal. The entire cash flow of a zero-coupon bond occurs at maturity, so the fulcrum is located directly below this one payment.
Duration of a Vanilla or Straight Bond
Consider a vanilla bond that pays coupons annually and matures in five years. Its cash flows consist of five annual coupon payments and the last payment includes the face value of the bond.
The moneybags represent the cash flows you will receive over the five-year period. To balance the red lever at the point where total cash flows equal the amount paid for the bond, the fulcrum must be farther to the left, at a point before maturity. Unlike the zero-coupon bond, the straight bond pays coupon payments throughout its life and therefore repays the full amount paid for the bond sooner.
The fulcrum must now move to the right in order to balance the lever again:
Duration increases immediately on the day a coupon is paid, but throughout the life of the bond, the duration is continually decreasing as time to the bond’s maturity decreases. The movement of time is represented above as the shortening of the red lever. Notice how the first diagram had five payment periods and the above diagram has only four. This shortening of the time line, however, occurs gradually, and as it does, duration continually decreases. So, in summary, duration is decreasing as time moves closer to maturity, but duration also increases momentarily on the day a coupon is paid and removed from the series of future cash flows – all this occurs until duration, eventually converges with the bond’s maturity. The same is true for a zero-coupon bond
Duration: Other factors
Types of Duration
The formula usually used to calculate a bond\’s basic duration is the Macaulay duration, which was created by Frederick Macaulay in 1938, although it was not commonly used until the 1970s. Macaulay duration is calculated by adding the results of multiplying the present value of each cash flow by the time it is received and dividing by the total price of the security. The formula for Macaulay duration is as follows:
Remember that bond price equals:
So the following is an expanded version of Macaulay duration:
Example 1: Betty holds a five-year bond with a par value of $1,000 and coupon rate of 5%. For simplicity, let’s assume that the coupon is paid annually and that interest rates are 5%. What is the Macaulay duration of the bond?
= 4.55 years
Fortunately, if you are seeking the Macaulay duration of a zero-coupon bond, the duration would be equal to the bond’s maturity, so there is no calculation required.
Let’s continue to analyze Betty’s bond and run through the calculation of her modified duration. Currently her bond is selling at $1,000, or par, which translates
= 4.33 years
Our example shows that if the bond’s yield changed from 5% to 6%, the duration of the bond will decline to 4.33 years. Because it calculates how duration will change when interest increases by 100 basis points, the modified duration will always be lower than the Macaulay duration.
Effective duration requires the use of binomial trees to calculate the option-adjusted spread(OAS). There are entire courses built around just those two topics, so the calculations involved for effective duration are beyond the scope of this tutorial. There are, however, many programs available to investors wishing to calculate effective duration.
In essence, key-rate duration, while holding the yield for all other maturities constant, allows the duration of a portfolio to be calculated for a one-basis-point change in interest rates. The key-rate method is most often used for portfolios such as the bond ladder, which consists of fixed-income securities with differing maturities. Here is the formula for key-rate duration:
The sum of the key-rate durations along the curve is equal to the effective duration.
Duration and Bond Price Volatility
Factors 1 and 2: Coupon rate and Term to Maturity
If term to maturity and a bond\’s initial price remain constant, the higher the coupon, the lower the volatility, and the lower the coupon, the higher the volatility. If the coupon rate and the bond\’s initial price are constant, the bond with a longer term to maturity will display higher price volatility and a bond with a shorter term to maturity will display lower price volatility.
Therefore, if you would like to invest in a bond with minimal interest rate risk, a bond with high coupon payments and a short term to maturity would be optimal. An investor who predicts that interest rates will decline would best potentially capitalize on a bond with low coupon payments and a long term to maturity, since these factors would magnify a bond\’s price increase.
Factor 3: Yield to Maturity (YTM)
The sensitivity of a bond\’s price to changes in interest rates also depends on its yield to maturity. A bond with a high yield to maturity will display lower price volatility than a bond with a lower yield to maturity, but a similar coupon rate and term to maturity. Yield to maturity is affected by the bond\’s credit rating, so bonds with poor credit ratings will have higher yields than bonds with excellent credit ratings. Therefore, bonds with poor credit ratings typically display lower price volatility than bonds with excellent credit ratings.
All three factors affect the degree to which bond price will change in the face of a change in prevailing interest rates. These factors work together and against each other. Consider the chart below:
So, if a bond has both a short term to maturity and a low coupon rate, its characteristics have opposite effects on its volatility: the low coupon raises volatility and the short term to maturity lowers volatility. The bond’s volatility would then be an average of these two opposite effects.
For example, say a bond has a two-year term with four coupons of $50 and a par value of $1,000. If the investor did not reinvest his or her proceeds at some interest rate, he or she would have received a total of $1200 at the end of two years. However, if the investor were to reinvest each of the bond cash flows until maturity, he or she would have more than $1200 in two years. Therefore, the extra interest accumulated on the reinvested coupons would allow the bondholder to satisfy a future $1200 obligation in less time than the maturity of the bond.
[…] Source: The Financial Engineer […]