Bond duration is one of the biggest and most important things to understand when managing a portfolio that includes bonds or other fixed income assets. Managed well, bond duration can give the chance for huge capital gains profits. Managed poorly, bond duration can wipe out a supposedly conservative bond portfolio in no time, leaving nothing but a capital losses. This is precisely the sort of topic that is important but can’t be discussed because it will scare away most new investors.
The heart of bond duration is the idea that interest rates matter when you value things. In fact, interest rates matter a lot. The value of all assets are influenced by interest rates. All else being equal, there are two rules you need to memorize:
- When interest rates fall, the value of all assets increases.
- When interest rates rise, the value of all assets decline.
The reason behind these two facts is that a shift in interest rate changes your “opportunity cost” – that is, the amount you could earn on your money by doing other things with it such as put it in the bank or pay off debt. This leads to another rule:
- The further in the future you expect to part with or receive cash, the more powerful the effect of the first two rules will be.
That is, if you are set to receive $1,000 for a bond 30 years from now and interest rates increase, the value of your bond is going to plummet compared to a bond that matures 1 year from now. This has to do with discounting cash flows in the time value of money.
The further in the future your bond (or other asset) is expected to generate cash flow for you, the higher its duration is said to be. That is why experienced investors are obsessed with bond duration and making sure it doesn’t get out of control in their portfolios. Property and casualty insurance companies, and other firms with large bond portfolios, practice a risk management technique known as “asset / liability matching” whereby they attempt to match the duration of bonds with the time period when the cash needs for those funds is expected, while keeping an eye on protecting shareholders from potential interest rate shocks.
A Look at Bond Duration for Two Hypothetical Investors
Consider two bond investors, Brandon and Charles. Both have exactly $1,000,000 in their bond portfolio.
- Brandon owns $1,000,000 worth of McDonald’s bonds that pay 5% annually and mature in 30 years.
- Charles owns $1,000,000 worth of McDonald’s bonds that pay 5% annually and mature in 1 year.
The moment these bonds were issued, they had the following present values (note: I’m not going to teach you how to calculate and discount cash flows; that is what I’m working on for my second book and it is almost 3:30 in the morning – it’s too late to go into it):
- Brandon’s bond has a present value of $772,716 for the interest income he will receive over the next 30 years and $227,284 for the principal he will receive when the bond matures for a total present value of $1,000,000.
- Charles’ bond has a present value of $48,185 for the interest income he will receive over the next year and $951,815 for the principal he will receive when the bond matures for a total present value of $1,000,000.
Now, let’s consider two scenarios: A sudden rise in interest rates and a sudden fall in interest rates. How will both of these investors be affected?
The Effect of Bond Duration In a Rising Interest Rate Environment
If interest rates for similar bonds immediately and overnight rose to 10%, the bond duration will result in drastically different outcomes for our two investors.
- Brandon’s bond will have a present value of only $473,232 for the interest income he will receive over the next 30 years and $53,536 for the principal value he will receive at maturity for a total of $526,768. That means that he is sitting on an unrealized loss of $473,232 or 47.32% of his money! If interest rates remained constant, it would take him 30 years to get all of his money back and experience no loss. That is a long time to wait and the hit to his balance sheet will be immediate. He wouldn’t be able to sell out of the bonds without taking the loss.
- Charles’ bond would have a present value of $46,485 for the interest income he will receive over the next year and $907,030 for the principal value he will get back upon maturity for a total of $953,515. That is an unrealized loss of $46,485 or 4.65%! Of course, is Charles just waits the entire year, he will collect his entire $1,000,000 in full but if he needs to sell his bond early, he will be forced to take the loss.
The only difference between these two investors is the bond duration of their investment. Brandon has a loss of more than 10x the loss experienced by Charles simply due to the fact that his 30 year bond has a higher duration.
The Effect of Bond Duration In a Falling Interest Rate Environment
If interest rates for similar bonds immediately and overnight fell to 2% the bond duration will result in drastically different outcomes for our two investors. Only this time, they would experience capital gains.
- Brandon’s bond would have a present value of interest payments of $1,123,876 and a present value for the face value of principal on the bond he will receive back at maturity of $550,450 for a total of $1,674,326. Due to the high bond duration, a drop of 3% in interest rates resulted in a $674,326 profit, or 67.43% on his money!
- Charles’ bond would have a present value of $49,260 for the interest payments he will receive and $980,296 for the principal value of the bond he will get back at maturity in 1 year for a total of $1,029,556. That is a capital gain of $29,556 or 2.96% on principal if he sold the bond today.
Using Bond Duration As a Portfolio Management Strategy
You can probably see how bond duration could be used to make speculations on the direction of interest rates and how, if you were correct, the gains could be huge by choosing high duration bonds. Likewise, the losses could be massive if you turn out to be wrong and there is no way to predict the direction of short-term interest rates.
As I wrote on September 24th, I think we are living in the midst of one of the greatest bond bubbles in history. Money is effectively free and the yield on 2-year Treasury notes reached an ALL TIME low of 0.36% on Thursday, October 7th. Got that? All time. We can’t get any cheaper short of entering deflation, which I just don’t think is probable in the long-term for the United States based on the current evidence. (I was actually kind of pleased to see that Warren Buffett just came out and said almost the same thing, arguing that equities are far cheaper than bonds right now and that he can’t “imagine” someone wanting to put their money into long-term bonds under these conditions.)
That means that when the Federal Reserves determines inflation threatens to rear its ugly head, they will respond by raising rates. The faster the recovery, the quicker the rate increase will likely be. So a strong recovery would ultimately lead to rapid increases in bond rates. That would result in huge losses to long-term bonds with high bond durations. It’s just a function of mathematics and discounting cash flows.
In Response To Your Question About Bond Duration
James, you asked:
Do you have any thoughts on the Vanguard High Yield fund (VWEHX)? Just started putting money into it but it’s money I’m not looking to use for 20 years. The average maturity of the bond portfolio is about 6.5 years and they seem more conservative than most high yield funds. I’m 39 now and I’m hoping by the time I’m 60 it’ll be a resource for income since I won’t have a pension. Do you think the fund is going to get killed as interest rates rise or do you think their average maturity will allow them to adjust?
First, let me be abundantly clear about something. I do not make buy, sell or hold recommendations about specific investments. I have no opinion about this security or any security. I am a private investor who is managing his own money. I am not a financial adviser. I am not a broker. All I do is explain to people how I think about specific investments and value investing in particular. I could be completely wrong. Anything I say is pure speculation on my part. If you listen to it, you very well could end up down by the river, homeless, with no home and no savings. I vehemently and passionately disavow any responsibility for any statement on this site or in response to this question. You proceed at your own risk.
Specifically, you asked about the bond duration of a fund with a 6.5 year horizon (which is considered intermediate) so I’ll talk about that and ignore credit quality concerns (if you own a bond portfolio and the underlying credit quality is bad or the particular type of bond suffers a liquidity crisis, that would cause a fall in value that would have nothing to do with interest rates).
- If the bond interest rate increases came over a period of several quarters or years, which is likely, the effect would be more muted because each quarter that passed would bring you closer to your maturity date and thus dampen the influence of interest rate swings on net present value.
- If you plan on holding a bond fund for the same length of time as the underlying bond duration value and there is no risk you may need to liquidate early, these fluctuations became more of an academic abstraction rather than a practical problem. That is, if interest rates did skyrocket suddenly and a 6.5 year bond duration fund dropped in value, but you were able to hold on for another 6.5 years, the unrealized losses you saw on your account statement during that time period should be recovered.
To put that in practical terms, if it took 2.5 years from now for rates to be back to where they were a few years ago, you’d only be the equivalent of 4 years out from the original duration at the time of your purchase.
If it were me, I planned on holding the bond fund for at least 5 years, there was absolutely no way, under any condition, that I would have to sell the fund prematurely, and I was insistent upon having some fixed income portion in my portfolio, a 6.5 year duration wouldn’t panic me at this point. I’d be fine with it. You said you plan on investing in this fund for 20 years, which reduces much of the duration risk.
The specific fund you asked about, though, is a junk bond fund. It is a junk bond fund in the honest-to-goodness definition of the word. It buys high risk junk. According to the description:
It invests at least 80% of assets in corporate bonds that are rated below Baa by Moody’s and have an equivalent rating by any other independent bond-rating agency; or, if unrated, are determined to be of comparable quality by the advisor. The fund may not invest more than 20% of assets in bonds with credit ratings lower than B or the equivalent, convertible securities, and preferred stocks.
That means, if the world went off a cliff again and the economy turned south, bond duration is not the biggest problem a fund like that would be facing. More likely, it would be the underlying default of the bonds held in the portfolio, which could cause significant and substantial losses.
[mainbodyad]My preference, but this is entirely me, would be to find a high quality real estate investment in a town I knew and get a 10% or greater cap rate (return) and that didn’t require much, if any, debt against it. Heaven knows I would never have more than a nominal portion of my portfolio in a junk bond fund! The words of the father of value investing, Benjamin Graham, ring out in my ears, “More money has been lost reaching for a little extra yield” than almost any other mistake in investing. You’re reaching for yield right now. Unless you’ve done a detailed study of the underlying securities held by that fund and have a reason to think they will perform better than the market expects, and even then you could be wrong.
That is, to say, the 6.5 year duration wouldn’t bother me alone. The 6.5 year duration, coupled with a junk bond fund? I know that given my own opportunity costs I could generate higher returns with far less risk so I wouldn’t touch it with a 10 foot pole. But that is me. I have no idea what is appropriate for you and, frankly, given that I am not a financial advisor, I wouldn’t tell you even if I did.
A Way to Get Around Bond Duration Problems
One way to get around bond duration problems on a decent sized portfolio for an average American is to invest in United States savings bonds such as I Bonds. The reason? In most cases, savings bonds have no effective duration (that is, a bond duration of zero) because they can be sold back to the government at any time at their intrinsic value.
How to Calculate Bond Duration
Seriously? No. I might include this in my new book but there is absolutely no practical reason for the average investor to have to manually calculate the duration of a potential fixed income investment. Most online resources can now tell you the average bond duration for a specific security or a bond fund. It would be a waste of time and energy to calculate it yourself unless it were vital to your risk management procedures, such as an insurance investment officer. Even then, I’d guess most just take the figures off the Bloomberg terminal on faith.