Duration And Why Bond Maturity Shapes A Portfolio

Two bond portfolios can hold issuers of identical creditworthiness and still move very differently when rates change. The difference is duration, and it is the main lever in bond allocation.

Duration measures rate sensitivity

Duration expresses roughly how much a bond's price changes for a given change in interest rates. A longer duration means a larger price movement in either direction.

It is derived from the timing of the payments a bond makes. Money arriving far in the future is more affected by a change in the rate used to value it.

This is why a bond maturing shortly barely moves when rates change, while one maturing in decades can move substantially on the same news.

The mechanism is discounting

A bond's price is the present value of its future payments. When prevailing rates rise, those fixed future payments are discounted more heavily and the price falls.

The payments themselves have not changed. What has changed is what the market will pay today to receive them, given that new bonds offer more.

The relationship works in reverse when rates fall, which is why long-dated bonds rise sharply in periods when rate expectations decline.

Falling prices and higher yields coexist

A rise in rates reduces the price of existing bonds while increasing the income available from new ones. A holder experiences a loss and a better reinvestment rate simultaneously.

For an investor with a long horizon, the improved reinvestment terms accumulate over time and can offset a great deal of the initial price fall.

For an investor needing the money shortly, the price fall is what matters, since there is no time for the higher yields to compound.

Duration should relate to the horizon

Matching the duration of a bond holding to when the money is needed reduces the effect of rate movements on the amount available at that date.

This is the principle behind funds whose bond duration shortens as a target date approaches, though the specific implementation varies between products.

A short-dated bond fund and a long-dated one are therefore not interchangeable, even though both may hold the same governments as issuers.

Bond funds never mature

An individual bond repays its face value on a known date. A bond fund holds a rolling portfolio and never reaches a maturity of its own.

The fund maintains an approximately constant duration by replacing bonds as they shorten, so its rate sensitivity persists indefinitely.

Fixed-maturity funds that hold bonds to a defined date exist in some markets, and their availability and structure differ by jurisdiction and change over time.