The rout in the bond market earlier this year left investors feeling shaky. And just as nerves were starting to steady, continuing weakness in the dollar prompted talk of another Federal Reserve interest rate hike. Nevertheless, bond prices have fallen so sharply that you may be entertaining the notion of buying again. If so, looking beyond yield to understanding
a bond's "duration" can come in handy. With things as unstable as they are, a lot of pros advise leaning toward shorter durations.
Duration is the measure money managers use to evaluate bond risk. It can help you limit your losses if interest rates rise or help you decide which of two bonds with similar yields and maturities is the riskier. It can also be used to compare the volatility of mutual funds. Duration isn't a factor if you hold bonds to maturity, but sometimes you have to cash out early. And if you're in a mutual fund, there is no set maturity to hold to. So with a lot of savings going into bond funds, duration is especially important. "Now, when the best of the bull market in bonds is behind us, everyone is looking at duration to invest defensively," says Marilyn Cohen, director of fixed income at L&S Advisors in Los Angeles.
The duration of a bond or bond fund is an estimation of how long it will take you to recoup your investment. It's a lot more precise than maturity because it takes into account the amount of the coupon, how frequently you get paid, and the price of the bond. It's calculated by multiplying the present value of each bond's payment by the number of years in which the payment is offered, then dividing the sum of these by the price of the bond.
The coupon payments are given decreasing value because inflation makes a dollar today worth more than in the future. Thus the sooner you get the money back, the more valuable it is. Since the value of the payments decreases over time, duration is usually shorter than maturity. One exception: zero-coupon bonds. Since you get no money back before maturity, their duration equals their maturity.
VOLATILITY. The longer your money is out on loan, the more at risk it is. So the higher the coupon, the faster you get your money back and the lower the duration. The lower the coupon, the longer the
duration. Compare two bonds with identical yields to maturity of 7.59% and similar maturities: A 22-year Treasury selling at $963.20 with a coupon of 7.25% has a duration of 10.66 years, while a 21-year Treasury at $1,378.60 with a coupon of 11.25% has a duration of 9.4 years. Thus, the second bond with the lower duration would be the better bet if rates were to rise.
Duration also can reveal how much the value of your bond mr fund will change for interest-rate swings of 100 basis points or less. If a bond or fund has a duration of five years, a 1% rise in rates will lower the price by 5%. If rates fall 1%, the bond's price will rise 5%. Therefore the longer the duration, the greater the volatility of your bond's price. A 20-year zero will lose 20% of its value if rates rise 1%. But if rates drop, you could reap a 20% capital gain.
So if you think the outlook for rates is still clouded, buy bonds with short durations; if you think rates will fall, buy bonds with long durations. Over the past two years, when L&S's Cohen thought interest rates had bottomed out, she reduced the duration in her municipal-bond portfolios from 9 to 4.25 years. "If my munis are 4.25, then a 1% move won't affect the portfolio by more than 4.25%," she says. Knowing that, "every month or quarter when you get your statement, you're not shocked that your principal is exposed."
In a bond fund managers calculate an average duration from the durations of many bonds. "The vast majority of bond funds have very specific duration targets," says Sanford Bragg, managing director at Standard & Poor's mutual-funds rating group. In fact, managers mften trade to maintain a given duration.
Companies that track the performance of mutual funds, such as Morningstar and Lipper Analytical Services, have added a duration calculation to income funds. A fund's duration may also shed light on a manager's strategy. If the fund is supposedly invested in intermediate Treasuries of 5 to 7 years and the company tells you the duration is 11, you know something's wrong because the duration can't be longer than the maturity, says Stan Carnes, chief portfolio strategist for the financial-services unit of Lehman Brothers. It may signal that the fund is boosting returns by adding riskier long-term bonds or mortgage-backed securities to the mix.
If you can't find a fund's duration, call the company and ask. "I get calls all the time for updates," says Robert Auwaerter, manager of Vanguard's taxable-bond-fund portfolios. Bond funds, unlike individual bonds, never mature, but they do allow you to keep your money invested at a specific target duration.
While duration may be the best measure of bond risk, it's far from perfect. It only calculates price volatility in response to interest rates, not total return based on income, says Ron Ryan, whose Ryan Labs in New York researches fixed-income securities. And as rates are constantly changing, so does duration, although it doesn't change a lot.
Duration can be applied to high-yield callable bonds and mortgage-backed securities, but it can get pretty obtuse with complex debt securities. It's really best applicable to Treasuries and to high-grade corporate and municipal bonds. If you stick to such bonds or funds that invest in them, it should be a helpful aid in the quest for yield and a discriminating ally in safeguarding your investments.
HOW BONDS REACT TO EVENTS Event Price Yield Duration INFLATION RISES Falls Rises Falls BOND AGES Moves toward Moves toward Falls par shorter-term rates BOND IS Usually falls Usually rises Usually falls DOWNGRADED CALL BECOMES Usually moves Moves toward Falls LIKELY toward call price shorter-term rates PRINCIPAL PAYMENT Falls Rises Rises slightly COUPON PAYMENT Falls Rises Rises slightly PREPAYMENT RATE Moves toward Moves toward Falls RISES par shorter-term rates DATA: LEHMAN BROTHERS INC.