Navigating Bond Markets
Understanding Maturity and Duration
Among the many factors that you should look at while buying or investing in a bond are its maturity and duration.
Maturity refers to the length of time until the bond's principal is repaid.
In short, maturity refers to the length of time until the bond's principal is repaid.
Generally, the longer the maturity of a bond, the higher the yield investors will demand, as the capital gets tied up for a longer period.
Investors seek a higher rate for a longer-duration bond because there is greater uncertainty about future economic conditions and interest rates.
As a result, longer-term bonds typically offer higher yields than shorter-term bonds.
Duration, on the other hand, measures the sensitivity of a bond's price to changes in interest rates.
Duration takes into account both the time to maturity and the bond's coupon payments and is expressed in years.
As interest rates rise, the price of a bond falls, and the longer the duration of the bond, the greater the fall in its price.
Conversely, as interest rates fall, the price of a bond rises, and again, the longer the duration of the bond, the greater the price increase.
In general, a bond with a longer maturity and duration will be more sensitive to changes in interest rates and, therefore, more volatile in price than a bond with a shorter maturity and duration.
This means that longer-term bonds are riskier investments, but they also offer the potential for higher returns.
How is duration used by investors?
The two main risks that can affect a bond's investment value are credit risk and interest rate risk.
An interest payment default or principal redemption failure is a credit risk, while yield change risk is primarily from interest rate fluctuations.
Duration is used to measure the potential impact that credit risk can pose on a bond price, as both factors impact a bond's expected yield-to-maturity.
Fixed income managers and investors often use Macaulay duration.
Macaulay duration is the weighted average time needed to receive all the cash flows from a bond and is expressed in years.
Simply stated, the Macaulay duration measures, in years, the amount of time required for an investor to be repaid the initial investment in a bond.
A bond's modified duration converts the Macaulay duration to estimate how much the bond's price will rise or fall for every percentage point change in the yield to maturity.
To sum up, modified duration is the measure of a bond's sensitivity to interest rate changes.
The more the Macaulay duration of a bond, the higher the resulting modified duration and volatility to interest rate changes.
The Securities and Exchange Board of India requires asset management companies to use Macaulay duration to differentiate among debt mutual funds based on the duration of the bonds or fixed-income securities in the portfolio.
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