Bond investors have lots of data to consider — from credit quality to call provisions. But two gauges, maturity and its second-cousin duration, may be among the most important as bond owners face the perils of today’s rising interest rates.
Once the investor has decided between low and high credit quality, it is maturity and duration that indicate how much risk is built into a given bond or fund. Experts say the two terms, and duration especially, are commonly misunderstood.
“Bonds are so misunderstood by investors, and by about 90 percent of advisors,” says Bill DeShurko, chief investment officer at FundTraderPro, a 401(k) investment management service in Centerville Ohio.
“Duration measures a bond’s sensitivity to changes in interest rates,” and is invariably a shorter period than maturity, which is the time until a bond’s principal is repaid, says Nicole Tanenbaum, chief investment strategist Chequers Financial Management in San Francisco.
[See: 7 of the Best Stocks to Buy for 2018.]
“Bond prices and interest rates move in opposite directions,” Tanenbaum says.
“Duration helps us roughly quantify how impactful that relationship can be for a given bond or bond portfolio,” she adds. “Two bonds can have the same maturity but very different durations, which means that they could be impacted by changes in interest rates very differently.”
Today’s conditions are particularly worrisome, as rising rates could hammer bond prices, and many experts are advising clients to switch to bonds with shorter maturities and durations. Some are sounding an alarm.
“I recommended to my clients that they sell all bonds last year,” says Joel Salomon, owner of SaLaurMor Capital in New York City.
Here is a quick look at how investors can use these two numbers.
All bonds are loans from the bond buyer to the issuer. If you pay $1,000 for a 10-year bond yielding 2 percent, you earn $20 a year for 10 years and then get back your $1,000 in principal. Three years after the purchase your bond will have a seven-year maturity, and so forth.
Bonds with longer maturities generally offer higher yields because investors demand more for tying money up.
But an investor who might want to sell a bond before it matures, or could have to, has more to think about since a bond’s value can rise or fall before it matures. No one will pay $1,000 for a 2 percent bond if they can buy a 4 percent bond for the same price, so the older bond’s price will drop until the fixed coupon payment — $20 a year, in this case — equals the 4 percent paid by new bonds. The price would drop to $500, because $20 is 4 percent of $500.
In real life it’s more complicated because interest earnings can be reinvested at the higher rates, and other factors weigh in, as well. But there’s no escaping the fact that small changes in yields can create big price drops, or gains if rates fall.
The investor can avoid a loss when rates rise by keeping the bond to maturity, but that means living with below-market earnings until then.
This whipsawing of bond prices as rates change is more pronounced with long maturities because the investor will experience the below- or above-market yield for longer. A bond nearing its maturity generally trades for close to its face value regardless of what happened to it in the meantime.
[See: Warren Buffett’s 8 Favorite Stocks.]
Investors who buy bonds through funds have an additional problem. Funds never reach maturity because they must constantly buy and sell bonds to maintain a promised average maturity. That means the fund investor cannot simply wait out a downturn in bond prices to a set date as an investor with individual bonds can do.
This is where duration comes in. While it can be applied to individual bonds, it is especially useful in evaluating risks in bond funds because it describes this interest-rate risk.
The math can be difficult, but basically duration says how long it will take to get your money back from interest payments and return of principal from a sale or maturity. Duration tells how much the fund’s value will rise or fall with every percentage point change in rates. A five-year duration means the fund could lose 5 percent if rates rise by 1 percent, or lose 10 percent if rates go up 2 percent. The longer the duration, the riskier the fund.
In practical terms, duration tells how long it will take interest payments to make up for a loss of value from rising rates.
“For estimating interest rate risk and approximate changes in value for a given change in rates, utilizing duration is critical,” says Robert R. Johnson, president of the American College of Financial Services in Bryn Mawr, Pennsylvania.
“If you expect interest rates to rise — and most expect interest rates to rise substantially over the next few years, me included — it would behoove investors to lower the durations of their bond portfolios,” he says.
But using duration is not as simple as it looks at first glance, DeShurko cautions.
“If you are evaluating two bond funds with the same yield but different durations, an investor might go with the lower duration, thinking it would be less volatile if rates go up,” he says.
But the two funds could nonetheless behave differently depending on the credit quality of the bonds they own. Neither maturity nor duration takes credit quality into account.
Also, duration in a bond fund, while a good measure of interest-rate risk, is not a guarantee investors will be made whole in the time specified, since many factors affect fund share prices.
Finally, DeShurko says, investors should remember that a bond purchase is not just a way of locking in today’s yield but a bet on future yields. Get it right and today’s yield will beat what you could get in the future. Get it wrong and you might kick yourself for tying money up at a low rate.
Currently, he says, the difference between short- and long-term yields is relatively small, suggesting this “yield curve” could “invert,” so that short-term rates will be higher than long-term rates. While that possibility could lead one to lock in today’s long-term rates, he thinks that’s too risky.
[See: 9 Ways to Invest in America With Bond Funds.]
DeShurko suggests investors keep their durations to five to seven years or less, so they can minimize risk and reinvest at higher yields of better deals come along in the near future.
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Bond Investors Need to Know About Maturity, Duration originally appeared on usnews.com
