Do you own bonds or have money invested in a bond fund? If so, given that the Federal Reserve has signaled a decision to begin raising interest rates, now is a good time to brush up on two factors that can drag down bond prices and fund returns—interest rate changes and a bond's duration.
The two are correlated. A well-known maxim of bond investing is that when interest rates rise, bond prices fall, and vice versa. This is also referred to as interest rate risk. And some bonds are more sensitive to interest rate changes than others. That sensitivity is known as a bond's duration. That's not to be confused with a bond's maturity, which is simply the date on which a bond issuer must repay the principal of a bond to the bond holder in full. Generally, the higher the duration, the more sensitive your bond investment will be to changes in interest rates.
Let’s dig deeper.
Bonds and Interest Rates
So, why do bonds tend to fall in value when interest rates rise?
Let's say you bought a $1,000 bond with a 10-year maturity and a 6 percent coupon rate at face value. Now let's jump forward. If one year later, interest rates have gone up and a comparable bond is issued with a 7 percent coupon rate, suddenly the bond you are holding looks less appealing to potential purchasers.
If you wanted to sell your bond before it matures, you'd likely have to sell at a price below face value, because investors now expect to be making 7 percent.
Conversely, if interest rates decline, your bond would suddenly look more attractive, and would likely demand a price higher than face value should you to sell it before maturity.
If you’re a “buy and hold-to-maturity” bond investor, interest rate changes may have little or no direct impact on your financial situation since the market price of a bond doesn’t matter much if you aren’t looking to sell.
Bond duration is a measure of the degree to which a bond investment is likely to change in value if interest rates were to rise or fall. The higher the number, the more sensitive your bond investment will be to changes in interest rates.
Generally speaking, for every 1 percentage-point change in interest rates, a bond will rise or fall in the opposite direction by an amount equal to its duration number.
For example, if a bond has a duration of 10 and interest rates increase by 1 percentage point, then that bond's price would be expected to decline by approximately 10 percent. If interest rates were to decline 1 percentage point, the bond's price would be expected to increase approximately 10 percent.
The calculations used to determine duration generally take into account a number of factors such as how much interest a bond pays during its lifespan, as well as a bond's call features, yield and time to maturity. In general, the higher the coupon rate, the lower the duration and the longer the maturity, the higher the duration.
To find a bond fund's duration, look at the fund's Fact Sheet, which you can find on the fund company’s website. The duration can often be found in the “Bond Holding Statistics,” “Key Facts” or “Portfolio Data” sections.
Finding the duration of an individual bond can be trickier. Start by asking your investment professional or brokerage firm.
One final point. Just because a bond or bond fund has a low duration doesn’t mean it is low risk. In addition to duration risk, bonds and bond funds are subject to credit risk, default risk, inflation risk, call risk and other risk factors.
It's important to read a bond's offering document or a bond fund's prospectus to learn about all of these risks. For more on the various risks bonds pose, check out What You Need To Know Before Investing In Bonds.