Watch Your Duration When Rates Rise

market bondsMatt Tucker explains what “duration” is and how to think about it in a rising interest rate environment.

While recent market volatility is leading many investors to look for the nearest exit, my colleague Russ Koesterich insists it’s time to stay the course while acknowledging that we may encounter some more bumps down the road.

He has some suggestions for bond exposure, specifically sectors that look more attractive right now.

Brendan Howard / Shutterstock

Brendan Howard / Shutterstock

Duration is a term we use in the bond world that can help us determine an investment’s interest rate risk. Today, I’ll explore the basics: What duration means and how to apply it to your bond strategy.

Deciphering Duration

When interest rates fluctuate, bond prices also shift. Rising rates push bond prices lower, while falling rates push bond prices higher. Duration, expressed as a number of years, measures a bond’s interest rate sensitivity: The higher the duration, the higher the interest rate risk. This means that if interest rates rise the price of a high duration bond will fall more than the price of a low duration bond.

Short, Medium and Long Duration

In fixed income, investors use the term “short” to denote a low duration, and “long” to denote a high duration. The duration of a bond is related to its maturity, with longer maturity bonds generally having higher durations. To be fair, longer maturity bonds don’t always have longer durations, but this is the case more often than not. Let’s take a look at some definitions for different duration ranges.

1. SHORT DURATION

When we say “short duration”, we are generally referring to bonds that mature within three years. Short duration bond strategies tend to have lower yields than long duration bond strategies, but when interest rates rise, short duration strategies will experience a smaller price drop.

2. MEDIUM DURATION

This refers to bond funds with average maturities of 3 to 10 years. Usually, yield is higher with these types of bond strategies than with short duration, while interest rate risk is lower than long duration.

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