A Helpful Yardstick For Anxious InvestorsJeffrey M. Laderman
Investors know that risk in the bond market is directly related to maturity of the bonds. If rates go up, a 30-year bond is going to fall further than a three-year bond. That's because the 30-year bond will be paying a lower-than-market interest rate for a very long time, while the holder of the three-year bond will only have to suffer for a few more years.
But maturity doesn't tell the whole story. Bonds with the same maturity but different coupons can behave much differently in a changing-rate environment. For instance, a 10-year bond with an 8% coupon will be less risky than a 10-year with a 6% coupon. Why? Because with a higher coupon, more money comes back to the investor sooner. And the faster your money comes back, the less the risk for holding that bond.
DANGER LOOMING? Bond-fund managers calculate that risk and call it "duration." The duration number tells how much the bond will change in price in response to changes in interest rates. The lower the duration, the less risky the bond. A bond fund's duration is the weighted average duration of the bonds that are in the fund.
Look at Vanguard's corporate-bond funds in the accompanying table. The duration of the short-term fund is 2.3 years. Compare that with the long-term bond fund, which has a 7.5-year duration. If interest rates go up 1 percentage point, the short-term fund will fall 2.3% in market value while the long-term fund will fall 7.5%. (If rates go down 1 percentage point, the long-term fund will rise 7.5% and the others will have proportionate gains.)
You can also use duration to measure relative risk among bond funds. Divide the duration of the long-term fund by that of the short-term fund. The long-term fund's duration is 3.3 times greater than the short-term's--and it's 3.3 times more risky. Or looking at it another way, the short-term fund has about one-third the risk of the long-term fund.
The biggest problem with bond-fund duration is obtaining the data. They are not available in newspapers or most mutual-fund reports. Morningstar Inc., which supplied the data for BUSINESS WEEK's Scoreboard, found that duration figures provided by funds were inaccurate, unavailable, or calculated in ways that made fund-to-fund analysis unreliable. So Morningstar is now crunching its own numbers by calculating a duration for every bond in a fund's portfolio--a cumbersome and still-imperfect process. And it's done only for a fraction of all bond funds.
The best place to obtain information on bond-fund duration is from the management company--if it provides any. A Vanguard representative was able to report the duration over its 800 telephone number. "Few people ask for the duration," reports Ian A. MacKinnon, who heads that company's bond funds. "I wish more people would use it." Considering everything that happened during 1994, perhaps they will.