Practical Uses of Duration and Convexity for Bond Buyers

Bond investors should consult their stomach barometers; open-end fund investors, their goals.
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In this third and final installment of Fixed-Income Forum's miniseries on

duration and

convexity, we discuss basic practical uses of the two concepts for the individual investor.

First, let's talk about buyers of individual bonds.

If you're buying an individual bond or assembling a portfolio of them, the duration of the individual securities and of the entire portfolio should at least be of interest to you, since it gives you an approximate idea of their sensitivity to changes in interest rates. Remember, a bond or a portfolio with a duration of five years will go down in price by approximately 5% in the event its yield rises by 100 basis points (and rise by approximately 5% if the yield falls by that amount).

If you intend to hold your bonds until they mature, their prices will eventually recover and you won't lose any money (assuming no defaults). "You're not going to have price risk if you're holding them to maturity," says William Guthrie, a certified financial planner with

Mellon Bank

in Pittsburgh. This point is especially important to investors who buy zero-coupon bonds. The duration of a zero will always be longer than any other bond you can buy, all else being equal. But if a zero suits your investment goal better than anything else would, so what? (More on this topic in an earlier

Fund Forum.)

Still, it's useful to know your duration because of what money manager Marilyn Cohen, president of

Envision Capital Management

in Los Angeles, calls "the stomach barometer."

" If interest rates move up a lot," she explains, "can your stomach tolerate a big dip in the value of your principal, even though you know you're going to hang on to the bonds until they mature? Because paper losses mean something very different to some people than to others."

Unfortunately, without the assistance of a financial professional or complicated software, it's not yet very easy to figure the duration of a bond portfolio. (The duration of an individual bond is easy enough to calculate with a bond calculator. I've never found a free one on the Web that's good enough, but the Web site

Bondsonline offers a very good one for $24.95.)

Nor is it easy to find out how your bond's or portfolio's duration compares to the duration of whichever market (Treasury, corporate, municipal) you're investing in. There are dozens of bond indices from firms like

Lehman Brothers

,

Salomon Smith Barney

and

Merrill Lynch

that track the various fixed-income markets. And the indices, being composed of bonds, have durations. Many bond portfolio managers peg the durations of their portfolios to whichever index they are using as their benchmark. Unfortunately, bond index data are pretty closely guarded. Merrill Lynch is the most generous of the bunch, posting a weekly bond index report on its

Web site.

Fortunately, as an individual investor, the duration of the market shouldn't necessarily matter to you. Assuming you're not planning on trading your bonds (in which case you presumably know more about all this than I do anyway), you may be able to afford to take more interest-rate risk (in exchange for greater returns) than a mutual fund manager who's worried about protecting his net asset value. For your purposes, Marilyn Cohen's stomach barometer is probably the more important measure.

As for convexity -- that feature that callable bonds don't have -- the implication for the individual bond investor is fairly simple. Don't buy a bond without knowing whether it's callable, and if so, when and at what price. And unless you have good reason to believe the bond is practically certain not to be called, buy it based on its yield to worst call, not based on its yield to maturity. Whoever's selling you the bond, in person or online, should be telling you what that is.

In general, investors in bond mutual funds probably don't need to concern themselves to the same degree with duration and convexity. That's not to say those things aren't important to bond funds; in fact, they're a key determinant of performance. But when you go to select a bond fund, they shouldn't be the first thing on your mind.

The first thing on your mind should probably be whether you want taxable or municipal bonds. Then, if you want taxables, where you belong on the credit-quality spectrum: in a Treasury, government, corporate or high-yield fund? Then, if you're going to pick one of the first three, where do you belong on the average maturity spectrum: in a short-, intermediate- or long-term fund? (Obviously, these funds are going to have different benchmarks with different durations.) Finally, only if you're considering an intermediate- or long-term fund is duration really an issue.

And even then, the decision you have to make is not about duration per se, but about whether you're investing primarily for income or for total return (please see an earlier

discussion on this topic), so you can pick a fund with the same orientation. A fund's basic literature should tell you whether the fund guns primarily for income, in which case its duration probably won't go much longer than the duration of its benchmark, or for total return, in which case it might.

The one class of fund investors that needs to concern itself with the callability of bonds in the fund is closed-end fund investors, especially muni closed-end fund investors. That's because most long-term muni bonds are callable 10 years from their issue date, and loads of closed-end muni funds came into existence in the late 1980s and early 1990s, when muni yields were much higher than they are now. There's a high probability those funds will have lots of their bonds called away in the next few years. Before you pay a premium for a muni closed-end fund with a nice high yield, look into whether the fund is likely to lose a large portion of its high-coupon bonds in the next few years. Because if it is, the dividend is likely to fall, taking the share price down with it. (A recent

Fund Forum discussed researching closed-end funds.)

Send your questions, along with your full name, to

fixed-incomeforum@thestreet.com.

TSC's Fixed-Income Forum aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.