When we talk of bond funds, we often get to hear the word Duration used commonly. What exactly is this duration and how does it affect your decision about debt funds. Interestingly, complex as it may seem, the concept of duration is actually quite simple. For bond traders, it is a useful tool for trading across bonds. For mutual fund investors it is not necessarily to get into those complexities. A basic understanding of the concept of duration and its implications would be more than sufficient.
Duration measures the time taken for you to recover your principal investment. Remember, when you invest in a bond you get coupons and the residual principal at maturity. If you invested in a bond with a face value of Rs.1000/- with a 10% coupon for 5 years, then you will get Rs.100 at the end of each of the first 4 years and at the end of 5th year you will get the interest plus the principal amount of Rs.1100/- In this case, since coupons are intermediate payments, the duration of the bond will be less than the term to maturity i.e. duration will be less than 5 years. Therefore any bond that pays coupon interest will have a duration that will be less than its maturity since the payback period starts with the coupon at the end of the first year. It therefore follows logically that in case of a deep-discount bond, the duration will be equal to maturity as there are no intermediate payments involved.
Understanding the key features of duration…
Firstly, duration is a function of the term to maturity. Other factors remaining constant, the longer the term to maturity, the longer will be the duration and shorter the term to maturity, shorter will be the duration. Thus a 5-year bond will have a longer duration than a 3-year bond.
Secondly, duration is also a function of the coupon interest payments. Higher the coupon payments, shorter the duration and lower the coupon payments, longer the duration. We have seen earlier that duration is the payback period of the bond including coupons. Thus higher coupons will result in a quicker payback and lead to lower duration. It therefore follows from this argument that deep discount bonds which are zero-coupon in nature will have duration that will be equal to the term to maturity.
Thirdly, frequency of compounding also matters. For example, a bond that compounds interest quarterly will have a lower duration than a bond that compounds on a half-yearly or annual basis. Here again the present value of inflows are faster when compounding is more frequent and thus the duration is lower.
Interpreting duration in practical terms…
There are two important practical applications for the concept of durations. Firstly, duration gives an agnostic base for comparison of bonds. Let us say you have to make a choice between bonds as a fund manager. One bond has a term to maturity of 10 years and pays 11% coupon on annual basis. The second bond has a term to maturity of 8 years and pays 10.5% coupon on a semi-annual basis. How do you compare apples and oranges? That is where duration comes in. You can compare these two bonds by calculating their duration. Duration factors term to maturity, coupons and periodicity of compounding and enables comparison of these two bonds.
Secondly, duration is an important measure of the sensitivity of the bond price to changes in interest rates. We are aware that there is an inverse relation between interest rates and bond prices. A rise in interest rates results in a fall in bond prices and a fall in interest rates results in a rise in bond prices. But how do you calculate the sensitivity of the bond prices to changes in interest rates? You can do that through duration. The impact on the price will be duration (times) the change in interest rate. For example, if the rates go up by 1% then a bond with duration of 5 years will fall by 5% and a bond with duration of 4 years will fall by 4%. How is this important to mutual fund holders?
Every bond fund today is required to disclose its duration as part of their portfolio disclosure. You can take a call based on whether you expect rates to go up or go down. For example if you expect rates to go up, you must focus on bond portfolios with lower duration so that price damage is limited. On the contrary, if you expect rates to go down, then prefer higher duration bond funds so that you get maximum benefit of price appreciation.
A final word in duration…
It is essential for mutual fund investors to understand the concept of duration as it helps them position their mutual fund holdings appropriately in consonance with their expectations of rates. A little clarity on this concept can go a long way in making you a savvier investor when it comes to bond funds.
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