After the shock that hit the financial markets over the past two years, investors are considering fixed-income assets but lack the tools to understand how they react to changes in interest rates. A basic metric known as duration can help investors understand the risks associated with debt.
Duration may be confusing to some since it's typically quoted either as a straight number or in years. The two forms are the same but viewed in different ways. When it's quoted in years, the number refers to the time before the initial investment is repaid. As such, a zero-coupon bond's duration is equal to its maturity. Securities that carry coupon payments will have durations that are less than maturity.
The more useful interpretation of duration views the number as the security's sensitivity to interest rate changes. Duration is the percentage change in the price of a security for a 100 basis point (bps) parallel shift in the yield curve. As a result, high-duration securities will be much more volatile when interest rates change than shorter-duration securities will be.
Calculating duration requires a bit of fiddling or a computer that runs
Excel. If you know the coupon, yield, price, settlement date and maturity date, the duration function in Excel can calculate the number. Otherwise, you need to recalculate the price of the bond with identical 100 bps increases and decreases in the yield.
After the price changes are calculated, the following formula will result in the bond's duration:
(Price for a negative 100 bps yield change - Price for a positive 100 bps yield change) / (2 X .01 X Current Price)
At its most basic level, duration will show that securities like a 10-year Treasury note with a duration of 8.29 will expose an investor to more interest rate risk than a 2-year Treasury note with a duration of 1.91. As a result, if an investor expects interest rates to increase, he would be better off in the 2-year note, since it will suffer a smaller price decline than the 10-year note. But if he expects interest rates to decrease, he ought to buy the 10-year note.
Digging deeper into duration, investors can use the metric to mitigate risk exposure. An investor looking for a high-quality corporate issue with a long time horizon and little price volatility may consider General Electric's 3 1/8 December 2019 bond as well as Exxon's 8 5/8 August 2021 bond as possible investments. Despite having a longer time to maturity, Exxon's bond has a shorter duration than GE's, meaning that investing in Exxon's bond would actually lead to less price volatility.
There are several drawbacks to duration. The measure assumes a parallel shift in the yield curve, which isn't usually what happens in the real world. Twists are far more common, so the duration measure isn't usually accurate. Also, duration is only descriptive for small shifts in the yield curve. As the price of a bond rises and falls, duration will also change. As a result, duration will have to be recalculated after yield-curve shifts and won't be descriptive for large changes.
-- Reported by David MacDougall in Boston.
Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.