What is Bond Duration and Why Should I Care?
You may have noticed that your bond funds almost always mention four key metrics: (1) credit quality, (2) average maturity, (3) interest rate, and (4) average duration. Credit quality measures the likelihood of a company defaulting on their debt. Average maturity is the time left before the bonds become due (pay their face value). Interest rate (sometimes called the coupon rate) is the percent of interest income you should expect to receive from your bonds on an annual basis (e.g. a $1,000 bond with a 3% interest rate will yield $30 in interest income annually.)
The final term – duration – is where people tend to get confused. But before I can explain duration you have to first understand how changes in interest rates affect bond prices. All you need to know is that interest rates and bond prices move in opposite directions. In other words, when you hear that interest rates are going up, you should expect to see your bond fund’s value go down. Why is that? Because everyone is rushing to sell their current bonds that have a relatively low coupon rate in order to buy the newly issued bonds with the higher coupon rates.
But wait, how can a person sell an old bond with an inferior interest rate? And who would be willing to buy the old bonds when they could just buy the newly issued, higher yielding bonds? Great question! A person would only be willing to buy the old bonds with an inferior interest rate if they could buy it at a discount. So sellers have to reduce their bond prices to find willing buyers. And that is why the value of old bonds (especially bonds with longer maturities) tend to decrease as interest rates rise.
So what does this have to do with duration? Duration measures how much your bonds are expected to rise or fall in value when interest rates change. The general rule is that for every 1% increase or decrease in interest rates a bond’s price will change about 1% in the opposite direction for every year of duration. So if interest rates rise 1% and your bond fund has a duration of 5 years then you should expect to see that bond fund’s value fall about 5%.
That’s all great, but why should anyone care about all these concepts and numbers? Because the Federal Reserve is expected to increase interest rates this year, which means that if you own bond funds with a high duration then you are likely going to lose money! Not sure what I mean? An example might help. Let’s say you own VGLT, a long term government bond fund and, at the time of this writing, it has a duration of about 17 years, but you decide to buy it because you really like the credit rating (“AAA”) and the yield (almost 3%). Unfortunately for you, if interest rates rise even half of a percent this year (0.5%) then your bond fund is expected to drop more than 8%!
So the next time you’re tempted to buy a long term bond fund don’t forget to check its duration.
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