The concept of ‘bond duration’, or rather bond duration risk, came to prominence in mid-March 2023, as the world was trying to understand the chain of failures of a number of US banks (including Silicon Valley Bank, Signature Bank and First Republic). The reason behind the collapse of these banks was that rapid rate hikes by the Federal Reserve (Fed) had depressed the value of their bond portfolios, causing a chain effect that led to their demise.
At that point, the public began to try to understand a concept that at first seems counterintuitive. After all, anyone could say that the duration of a bond is known as well as the yield. But nothing could be further from the truth, since understanding that duration is not the same as maturity and that yield is not the same as price is vital for any investor interested in bonds.
What is the duration of a bond?
A crucial aspect when investing in bonds is to be clear that the maturity and duration of a bond are not the same thing. The first concept refers to the life of the security, from the time the money is delivered and the bond is obtained until it is cancelled and the principal is returned, either to the investor himself or to another investor who has acquired it in the secondary market. On the other hand, the second concept refers to the time that elapses until an investor recovers the money invested, since as this debt security pays interest, coupons, it is usually smaller than the maturity.
Bond duration and interest rates
Informally, the duration of a bond is a measure of how long it takes to get our money back, but it is actually a much deeper concept that provides useful information about the bond itself. It is also a measure of the so-called interest rate risk that relates factors such as the maturity itself, the yield, the coupon and the options to be called (to have the principal repaid early), so that we obtain a number that measures its sensitivity to changes in interest rates.
Why is the duration of a bond so important?
The information provided by the duration of a bond is essential for any debt portfolio, as it allows us to understand how its value falls when rates rise and how it rises when rates fall. Thus, managers (and investors) try to condition their portfolio according to one situation or the other. Thus, if an investor expects interest rates to fall, he will prefer to invest in securities that lengthen the average duration of his bonds, since the value of his portfolio will increase more than that of comparable bonds with shorter durations.
The opposite may also happen, i.e., rates may rise, so that a portfolio with shorter duration bonds will be set up. Gambling is important, especially when holding large volumes of bonds. In fact, the main cause that brought down Silicon Valley Bank (along with others) was that the rapid rise in rates by the Fed caught them with a very long duration bond portfolio, which led to a huge loss of value of the securities at current prices with the chain of balance sheet breakage, liquidity problems and eventually bankruptcy.
How is the duration of a bond calculated?
When calculating the duration of a bond, we can opt for different formulas that relate the change in the price and interest of the bond, the evolution of the interest rate or the cash flows it returns. However, it is easiest to use the three main concepts that determine the duration of a bond:
- Maturity of the bond: the return of the principal is limited by the term to maturity, which implies that the longer the term, the longer it will take to recover our capital.
- Payment structure (coupons): when it comes to influencing the bond, the payment structure is important, since when we receive a larger amount of money on a recurring basis, it will take less time to obtain the invested capital.
- The interest rate: the interest generated is the main reason why the duration of bonds varies. After all, with the same nominal amount and the same maturity all bonds would last the same, however, it is the interest that makes it smaller (if it is higher) or vice versa.
- Interest rates (or IRR): obviously, if the interest rate moves in the duration of the bond, so does the evolution of rates. In this case, the key is whether they increase or decrease, as they are directly proportional, i.e., if rates decrease, so does the duration.
Building a bond portfolio with inbestMe
If you are going to create your own bond portfolio, you should bear in mind that it is as important to be familiar with the basic concepts of fixed income as it is to use a suitable platform to do so. Keep in mind that you should always think about a series of requirements: CNMV approval; transparency in the movements; that it has the backing of a good number of clients or competitive rates.
A good example of a platform that meets these requirements is inbestMe, since it has not only been in Spain for more than five years, bringing together satisfied customers, but its system has been improving. Its tools and strategies are state-of-the-art for building diversified bond portfolios that are optimized according to duration and other risk factors, which gives clients greater security. And with an ever-expanding product offering. In short, to avoid surprises and see your savings grow, choose inbestMe and benefit from the advantages of a leading platform.
