Measuring the risk in a bond requires more than the knowledge of its quality rating. There are, in fact, several standards by which risk is measured in the fixed-income markets, and quality risk or risk of default is just one of them. Perhaps more important, in terms of the total rate of return performance of a particular portfolio over a one or two-year time period, is the risk as measured by price volatility. Certainly over the past several years, substantial price swings have alerted investment managers and pension fund directors to the increased volatility and thus increased risk of their portfolios.
For years, the most common method of measuring price volatility or risk was by calculating the average maturity of a portfolio. Obviously, long-term bonds are more volatile than short-term issues, and an approximation of risk could be derived by averaging the maturities of all of a portfolio's individual issues. The problem with this approach however, is that average maturity is not an accurate proxy for the price volatility of a particular portfolio. For instance, a portfolio composed of 50% cash (1-day maturities) and 50% 20-year bonds is much less volatile than a portfolio composed of 100% 10-year notes. While both have average maturities of 10 years, the price behavior of each will be markedly different under varying interest rate scenarios.
The explanation for this odd behavior comes about via the concept of duration. Duration is a term that has recently been rediscovered but was originally thought of in the late 1930s by Frederic Macaulay. In brief, duration is the weighted average maturity of all streams of principal and interest from a bond or a portfolio of bonds. In contrast, maturity is the measurement of the time at which the principal only is due to be repaid. In effect, the receipt of interest is taken into consideration for duration but not maturity. By so doing, the duration of a bond with interest payments always turns out to be less than its maturity, since the interest payments are received prior to maturity and thus have a "shortening" effect on the average of all interest and principal receipts.
Now, the duration of a bond or portfolio of bonds would have little utility to money managers if it were not for the fact that duration is a more accurate measure of price volatility. Empirical studies have demonstrated that for most practical applications:
Duration = - % Price Change/Yield Change
For instance, say the duration of a 10-year Note is computed to be 6 years via the methodology previously described. Computing the price volatility for a given change in yield is straightforward.
If the pension fund director or portfolio manager believes that interest rates will rise by 100 basis points or 1%, then their price change would be:
6=-(X)/+100
and X would equal -6 percent
The Note will fall 6 percent in price then, for an upward change of 100 basis points in yield. It can be easily observed that by shortening duration, the price change up or down will be reduced for a given basis point move in yield.
Similarly, by increasing duration, volatility increases. Thus, in bull bond markets, logic would suggest an extension of duration for those accounts willing to assume the additional volatility or risk. In contrast, during bear markets as yields increase and prices decline, a shortening of duration might be appropriate.
The concept of duration is not a perfect one. While it explains much of the price movement of a particular bond or portfolio, it has some weaknesses. For instance, price changes due to changing quality spreads or changing spreads between sectors are not covered. In addition, portfolios with equal durations can behave differently in price due to changes in the shapes of the yield curve. If the shape of the curve changes at all (and it usually does), the price movement projections in the previous formula can be altered for a given portfolio. These exceptions are not enough cause, however, to discard the concept of duration. It is a helpful tool which allows money managers and pension fund directors to gauge the potential risk of their portfolios in terms of volatility. With the knowledge in hand of a portfolio's duration, any interested party can gauge the approximate total return of a portfolio, given numerous interest rate scenarios.
While the selection of securities is still the money manager's most vital task, duration management can be equally as vital. Actively managing the portfolio’s duration can help reduce the effects of interest rate risk on a client’s portfolio.
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Past performance is no guarantee of future results. This commentary is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. For more information please consult your financial advisor. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.
Diversification does not ensure against loss. The credit quality of the investment in the portfolio does not apply to the stability or safety of the portfolio.
Each sector of the bond market entails risk. Municipals may realize gains and may incur a tax liability from time to time. The guarantee on Treasuries and Government Bonds is to the timely repayment of principal and interest. Shares are not guaranteed. Mortgage-backed securities and Corporate Bonds may be sensitive to interest rates. When interest rates rise the value of fixed income securities generally declines. There is no assurance that private guarantors or insurers will meet their obligations. High-yield bonds typically have a lower credit rating than other bonds. Lower rated bonds generally involve a greater risk to principal than higher rated bonds. Investing in foreign securities may entail risk due to foreign economic and political developments; this risk may be enhanced when investing in emerging markets. A derivative instrument is a contract whose value is based on the performance of an underlying financial asset, index or other investment. Use of these instruments may involve certain costs and risks such as liquidity risk, interest rate risk, market risk, credit risk, management risk and the risk that a fund could not close out a position when it would be most advantageous to do so. Portfolios investing in derivatives could lose more than the principal amount invested in those instruments. Duration is a measure of price sensitivity expressed in years.
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