What is bond duration?
Many investors are asking: What does duration of a bond mean? Duration measures how much a bond’s price is likely to change given a corresponding change in interest rates. The connection has to do with the relationship between bond prices and interest rates. Generally, when interest rates rise, prices of existing bonds fall. For example, if rates rise from 2% to 3% for 10-year Government of Canada bonds, then existing 10-year bonds paying 2% interest become less attractive. Of course, the reverse is also true: If rates are falling, then existing bonds with higher rates become more attractive.
Duration is a way of gauging how sensitive your bond or bond fund is to changes in interest rates—also commonly known as interest-rate risk. The metric is measured in years. Essentially, for every 1% change in interest rates, a bond’s price will change in the opposite direction by 1% for every year of duration. All other things being equal, a bond with a duration of five years will be more sensitive to changes in interest rates than a bond with a duration of three years, but not as sensitive to changes as a bond with a duration of 10 years.
Bond duration and interest rates
Interest rates are expected to start rising after a prolonged period of being pinned to the floor by central bank policy. In January 2022, inflation in Canada stood at 5.1%; this is in sharp contrast to the average inflation rate of 1.6% in the ten years to 2020.1 In response, central banks the world over, including the Bank of Canada and the Federal Reserve, have signaled their intention to start raising rates this year. At the same time, longer-term rates, which are driven by market sentiment, have also started to creep up.
The good news is that duration varies widely across different types of bonds. For example, as of December 31, 2021, investment-grade U.S. corporate bonds had a duration of 8.58 years. The government-bond heavy Bloomberg Global Aggregate Bond Index had a duration of 6.77 years, while U.S. high-yield bonds have a duration of 5.18 years.2
In bonds, as in life, nothing comes for free. For example, the shorter duration on high-yield bonds comes with a different kind of risk that government bonds don’t have, which is credit risk—the risk of a bond issuer defaulting on its bond obligations.
What is a good bond duration?
Bond mutual fund managers actively adjust the overall duration of a portfolio by mixing different kinds of bonds and different maturities. According to Morningstar, the category average duration for multisector bond funds was 3.52 years, while nontraditional bond funds, as of December 31, 2021, had an average duration of 2.10 years. Managers of funds with the ability to invest overseas can also take advantage of the fact that rates seldom move in lockstep from one country to the next—they sometimes even move in opposite directions.
For investors with significant allocations to fixed income, deciding what is “good bond duration” depends largely on individual investment goals and investment time horizon. Now is a great time to ask your financial professional whether your bond funds have the appropriate level of duration, given the anticipated rising interest-rate environment. Reducing duration may well entail increasing exposure to a different kind of fixed-income risk, but it may be a balance worth striking should rates start to rise in the months ahead.
1 Statistics Canada. 2 Bloomberg, as of December 2021.
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