Question: Morningstar analysts often define duration as a "measure of sensitivity to interest rates." What exactly does this mean?
Answer: This is a timely question given all the question marks surrounding interest rates. Rates have been at historical lows for quite some time, and pundits have long speculated that rate hikes were imminent. But that hasn't happened yet; in fact, the Bank of Canada recently lowered its policy rate in light of the weak economy. Meanwhile, in the United States, the Federal Reserve last month signalled that it might raise rates later this year.
Duration helps investors grasp price fluctuations that are due to interest-rate movements. Essentially, bond prices have an inverse relationship with interest rates.
When Morningstar analysts refer to duration in the context of an overall bond portfolio, they are most likely referring to average effective duration. This is the weighted average of the durations of the portfolio's underlying bonds or derivatives' market exposures. Morningstar shows average effective duration on its fund quote pages, and it's reported to us by the fund company.
Understanding duration
To simplify the concept a bit, let's talk about duration in terms of a single bond. Let's say we bought a 10-year bond that is issued with a $1,000 principal value, or par value. Our $1,000 par value bond has a 5% coupon rate (annual fixed interest rate). If we hold the bond for 10 years, we will receive yearly payments of $50 (5% of $1,000), and then at the end of the holding period, we will get back the $1,000 principal value of the bond.
Like a bond's maturity, a bond's duration is expressed in years. But unlike maturity, which is the length of time until a bond's interest payments cease and its principal is paid back (in the case of our hypothetical bond, 10 years), the duration number also incorporates yield, coupon, maturity and call features.
You could think of duration as the number of years required to recover the true cost of a bond, taking into account the present value of all coupon and principal payments received in the future. Sometimes this is graphically illustrated as a lever and fulcrum, with the periodic cash flows arranged from left to right and the principal payout as a larger cash flow all the way to the right, at the end of the scale which represents the fund's maturity date. The fulcrum, or the point at which the lever balances, is the fund's duration.
Due to these payouts (in other words, because you're recouping some of the cost of the bond before maturity), the duration of an interest-paying bond will always be shorter than its maturity (or, in the lever diagram, to the left of the maturity date). The higher the interest rate, the shorter the duration -- this makes sense because the individual payouts are higher and the investor is recouping the cost of the bond faster.
How it relates to interest rates
Duration is a tool that helps investors anticipate and understand price fluctuations that are due to interest-rate movements. As mentioned earlier, bond prices have an inverse relationship with interest rates.
To illustrate, let's go back to our hypothetical 10-year bond with a $1,000 par value and a 5% coupon. Let's say we decide to sell this bond. But new 10-year bonds are being issued with 8% coupons. Why would someone want to buy our bond, which pays $50 per year, when he or she could buy one for the same price that pays $80 per year? To entice someone to buy our bond with its lower yield, we'll have to mark the price down to less than $1,000, thus raising the buyer's yield closer to 8%.
But the reverse is true in a falling-interest-rate scenario. If new 10-year bonds are being issued with a 3% yield, our 5% coupon bond looks a lot more attractive. A prospective buyer might be willing to pay more than $1,000 to own our 5% bond.
So, in simple terms, a bond's duration will estimate how its price will be affected by interest-rate changes. The longer a fund's average effective duration, the more sensitive the fund is to shifts in interest rates. In other words, if rates move up by 1 percentage point, the price of a bond with a duration of 5.0 years will move down by 5%, while a bond with a duration of 10.0 years will move down by about 10%.
That said, it's also important to factor in the yield, because it can act as a buffer. So, if rates move up by 1 percentage point, you get a 1-percentage-point increase in your yield to help offset the drop in your principal. For example, if yields go from 2% to 3% in a one-year period and your duration is 6.0 years, your 6% principal loss is offset by the small bump up in yield.
Not a perfect system
Although duration can be a useful tool in determining the interest-rate sensitivity of a bond or portfolio of bonds, it is far from a perfect measure. Even though two bond funds have the same average effective duration, they could still react differently to interest-rate changes if their underlying securities are different. Also, a fund with an average effective duration of 10.0 years may not be twice as sensitive to interest-rate changes as one with 5.0 years. For more on this, see Bond Fund Duration: An Art, Not a Science by Morningstar senior analyst Eric Jacobson.
Also, in his recent article Bond Portfolio Duration and the Flaw of Averages, Morningstar fixed-income analyst Thomas Boccellari makes the point that understanding a fund's yield-curve exposure can be a more useful tool than average effective duration in terms of helping investors better understand their fund's overall interest-rate risk.
Putting it in context
With interest rates at historic lows and speculation that rates may soon move higher, it makes sense for investors to pay attention to duration with regard to their overall bond portfolio's interest-rate sensitivity. But duration is far from the only consideration when investing in bond funds. Others things for bond-fund investors to consider include credit quality and bond type, not to mention fund management and fund fees.
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