Evaluating Duration
Investors and portfolio managers use duration to estimate how the value of a bond, or an entire bond portfolio, might change when interest rates rise or fall. Duration incorporates factors such as a bond's time to maturity, yield, coupon, and any call features.
Although duration is expressed in years, it is distinct from a bond’s maturity date. A bond’s duration reflects the weighted-average time it will take an investor to receive all the bond’s cash flows, including periodic coupon payments and the final return of principal.
What duration tells us
Duration can be calculated in several ways, but in most day-to-day applications, the term refers to "effective duration”. Effective duration estimates the approximate percentage change in a bond's price for a one-percentage-point change in yield.
The impact of interest rate movements
- As a general rule, a bond with a longer duration will experience a greater price decline than a shorter-duration bond when interest rates rise.
- This happens because: a) investors must wait longer to receive their principal, and b) the bond’s fixed coupon payments become less attractive relative to newly issued bonds offering higher coupons.
- The opposite occurs when interest rates fall: Bonds with longer durations tend to appreciate more than those with shorter durations.
The table below illustrates how a 1% change in interest rates can affect bonds with different durations:
Gauging interest rate sensitivity
Source: PIMCO. Indicative example for illustrative purposes only.
Active uses of duration
Among both individual investors and active managers, duration is one of the most widely used tools for assessing and managing interest rate risk. A portfolio’s average duration can be adjusted – by buying or selling individual holdings – to align with expectations for economic conditions and future interest rate movements.
- To maximise gains from a projected fall in interest rates, an investor might increase the portfolio's average duration.
- To position for an expected increase in interest rates, they could reduce the portfolio's average duration.
- A "negative duration” strategy can be used by investors who are confident that borrowing costs will rise. Such strategies are typically implemented using derivatives or short positions to create an overall negative sensitivity to interest rate changes, allowing the portfolio to generate value when rates move higher.
Using duration for portfolio selection
A portfolio’s duration profile can help investors select strategies and products that match both their risk tolerance and expectations for future interest rate movements.
If an investor is willing to assume additional interest rate risk and expects borrowing costs to fall, they may favour a portfolio with a longer duration.
More cautious investors, or those anticipating rising rates, may prefer a shorter-duration portfolio.
- Low-duration portfolio
Average duration: 1-3 years
This type of portfolio may offer the potential for higher returns than money market funds when interest rates are low, while maintaining relatively limited interest‑rate sensitivity. - Moderate-duration portfolio
Average duration: 2-5 years
Designed for investors seeking higher return potential than money market or low-duration strategies, while accepting a modest increase in interest rate risk. - Long-duration portfolio
Average duration: 6-25 years
A long-duration portfolio can help investors match assets to long‑term liabilities and may provide more predictable long-term cash flow characteristics than equity markets, albeit with greater sensitivity to interest rate movements.
The risks associated with a duration-focused investment approach
Investors should be mindful of several factors when using duration to select individual holdings or manage a broader bond portfolio.
- A portfolio's duration naturally changes over time as bonds mature and market yields fluctuate.
- Investors should therefore monitor their portfolio’s average duration regularly. In actively managed strategies, professional managers typically aim to keep the portfolio within a defined duration range.
- Duration is not an indicator of a bond’s or portfolio’s credit quality. For example, a high-yield bond may have the same duration as an investment-grade bond but still be far more exposed to credit-related risks, such as the impact of an economic downturn on its issuer.
To avoid unexpected outcomes, investors should review their portfolio’s duration profile frequently or consider actively managed strategies that maintain a consistent duration range.
