Your money: how the duration of a bond determines its degree of price risk

Long-term bond funds, also known as maturity-focused bond funds in the United States, present a substantial degree of price risk.

By Sunil K Parameswaran

Bond duration is a key issue of interest to bond market investors. Duration is a measure of the price risk of a bond. The term “price risk” refers to the risk that bond yields move in an unfavorable direction and have a negative impact on bond prices. If a trader is a bond buyer, his concern is that market returns will rise, which will cause his portfolio to fall in value. On the other hand, if a trader is short on bonds, their concern is that yields will fall, causing the prices of the bonds they have committed to buy to rise. As investors know, bond prices and yields are inversely related.

Interest rate sensitivity
The duration of a bond is a measure of its sensitivity to interest rates. For a given change in yield, the longer the duration, the greater the observed price change. So bullish speculators who bought bonds and bearish speculators who sold bonds short will both look for high duration portfolios. If the yields go as expected, they are likely to reap nice benefits. Of course, one of them will end up losing considerably. Any bond traded before maturity, whether it is a single coupon bond or a zero coupon bond, exposes its holder to price risk.

Cautious investors should opt for low to moderate duration bond funds, as these present less price risk. New investors may believe that all bond funds are equally risky and invest with confidence because they believe debt is a safer investment than stocks. It is a mistake. Long-term bond funds, also referred to as target maturity bond funds in the United States, present a significant degree of price risk.

Debt mutual funds can be categorized according to the length of the underlying portfolio. At the bottom of the scale, we have ultra-short duration and short duration bond funds. Then we have moderate duration bond funds as well as high duration bond funds. In the case of the latter two, capital gains can be substantial, as can capital losses.

Fixed maturity plans
Fixed maturity plans are an alternative from a debt fund perspective. In this case, the fund manager will hold the underlying portfolio until maturity. Since all bonds are held to maturity, they are certain to pay face value when due, unless of course the issuer defaults. It should be remembered that if a bond is held to maturity, there is no price risk, regardless of interest rate fluctuations in the intervening period, since all bonds will pay face value. at the due date. Fixed maturity plans are known as mutual funds in the United States.

This does not mean that bonds held to maturity are risk free. There is a risk of default, which applies to all bonds except government bonds. In addition, when coupons are received periodically, they must be reinvested. The risk that the rates will be lower than expected when the coupons are received is called reinvestment risk.

All bonds, with the exception of zero coupon bonds, expose their holder to reinvestment risk. This is true even for government bonds paying coupons. Zero coupon bonds do not present this kind of risk because there is nothing to reinvest. Therefore, if a zero coupon bond is bought and held to maturity, the only risk is the risk of default.

The author is CEO of Tarheel Consultancy Services