15 Sep Understanding Investments: Duration
Investors are generally aware that changes in interest rates affect the value of bonds. How and to what extent the value of a bond or a bond portfolio is affected by falling or rising interest rates can be measured by the Duration indicator, otherwise known as Duration.
What is the Duration of the Bond?
Duration is a measure of interest rate risk that takes into account the maturity, coupon, yield and other associated options of the bond. All these factors are synthesized in a single number that shows the sensitivity of the bond value to changes in market interest rates.
How do investors use Duration?
When interest rates rise, the value of bonds decreases and vice versa. Generally, the higher the maturity of a bond, the lower the value of the bond when market interest rates rise. If an investor expects interest rates to fall during the period that will hold the bond, a bond with a longer maturity would be more attractive to him because the value of the bond would increase more than comparable bonds with short term maturities, when the reduction of rates was realized.
As the table below shows, the shorter the maturity of a bond, the less volatile the value of the bond is likely to be. For example, a bond with a 1-year maturity would lose only 1% in value if rates increased by 1%. Whereas, a bond with a maturity of 10 years would lose 10% if the rates were to increase by the same percentage of 1%. Conversely, if rates were to fall by 1%, bonds with a longer maturity would earn more, while those with a shorter maturity would earn less.
Although Duration is a very useful analytical tool, it is not a complete indicator of bond risk. For example, maturity does not indicate anything about the credit risk of a bond. This may be particularly important for low-rated securities (such as high-yield bonds), whose value is equally or more sensitive to the issuer ‘s perception of financial stability than to changes in rates market interest.
Another limitation of using maturity when valuing a bond portfolio is that the average maturity of the portfolio may change as bonds within the portfolio mature and interest rates change. On the other hand, if the portfolio manager expects interest rates to rise, he may shorten the average portfolio maturity to minimize the negative effect on the value of the bond portfolio.
Concept of Duration in the “Credins Premium” Investment Fund
Credins Premium Investment Fund invests mainly in bonds and bonds issued and guaranteed by the Albanian Government. The average duration of the Credins Premium Investment Fund at the end of July is 3.53 years. As we explained above, market interest rates have a significant impact on the value of bonds and consequently on the value of the bond portfolio.
For this reason, all economic and political factors that affect interest rates are analyzed, in order to create the most accurate expectations for the performance of interest rates. Based on these expectations, the portfolio management unit builds tactical investment strategies in order to achieve the objective of the fund, maximize revenue while maintaining principal and liquidity.
How Do Portfolio Managers Use Duration?
Although Duration as an indicator has some limitations, it can be an extremely useful tool for bond portfolio building and risk management. When the Portfolio Manager’s interest rate expectations change, he may adjust the average portfolio maturity (by performing bond sale / purchase transactions in the portfolio) to match his forecast. These adjustments can be made to the portfolio as a whole, or to a specific sector within the portfolio. So if the portfolio manager expects interest rates to fall, the average portfolio duration can be extended to get the most out of the rate change.