This Day On The Street
Continue to site right-arrow
ADVERTISEMENT
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here
TheStreet Open House

Measuring a Bond's Interest-Rate Sensitivity

What is the difference between duration and average life?

-- Kevin Hwang

Kevin,

Bond duration and average life are different ways of measuring the interest-rate sensitivity of a debt security.

Duration, measured in years, is the amount of time it will take for a bond investor to receive half of the present value of all future cash flows (coupon payments and principal repayment) from the bond. The discount rate for calculating the present value of the cash flows is the bond's yield.

Duration gives you an indication of approximately how much a bond's price will change in the event its yield shifts by a full percentage point (100 basis points). A bond with a duration of 6 years will increase in price by about 6% if its yield sheds 100 basis points, and decrease in price by about 6% if its yield rises by 100 basis points.

Duration is a fine measure of interest-rate sensitivity for a regular, noncallable bond with future cash flows that are thoroughly predictable. The trouble is, in the vast world of debt securities, many, many of them are callable, meaning that the issuer retains the option to either retire the bond early or accelerate repayment of principal if interest rates fall. Investors get compensated for this with higher yields on callable bonds than on noncallables. But the bottom line is, the future cash flows from a callable bond are unpredictable, because they depend on what happens with interest rates.

So bond wizards developed a more complicated measure of interest-rate sensitivity for callable bonds called effective duration. Effective duration takes into account the fact that as interest rates change, cash flows will change as well. Obviously, it involves assumptions about how much a given change in interest rates will affect cash flows, and as such, it's part science, part art.

Average life, the subject of your question, is a predecessor of effective duration that was developed for analyzing mortgage-backed securities, explains Evan Firestone, director of mortgage research at Merrill Lynch.

Mortgage-backed securities, discussed at greater length in an earlier Fixed-Income Forum , have unpredictable cash flows because homeowners -- the effective issuers of the bonds -- have the option to prepay all or part of their loans at any time. That makes them some of the most complicated income securities to analyze.

1 of 2

Check Out Our Best Services for Investors

Action Alerts PLUS

Jim Cramer and Stephanie Link reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

Jim Cramer's protégé, David Peltier, uncovers low dollar stocks with extraordinary upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
Try it NOW
Try it NOW
Try it NOW

Check Out Our Best Services for Investors

Dividend Stock Advisor

Jim Cramer's protégé, David Peltier, identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Options Profits

Our options trading pros provide over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • Actionable options commentary and news
  • Real-time trading community
Try it NOW
Try it NOW
Try it NOW
To begin commenting right away, you can log in below using your Disqus, Facebook, Twitter, OpenID or Yahoo login credentials. Alternatively, you can post a comment as a "guest" just by entering an email address. Your use of the commenting tool is subject to multiple terms of service/use and privacy policies - see here for more details.
Submit an article to us!

Markets

DOW 17,164.95 -251.90 -1.45%
S&P 500 1,994.99 -26.26 -1.30%
NASDAQ 4,635.24 -48.1670 -1.03%

Partners Compare Online Brokers

Free Reports

Free Newsletters from TheStreet

My Subscriptions:

After the Bell

Before the Bell

Booyah! Newsletter

Midday Bell

TheStreet Top 10 Stories

Winners & Losers

Register for Newsletters
Top Rated Stocks Top Rated Funds Top Rated ETFs