If you expect interest rates to fall, buy the bond with the longest duration. When rates rise, sell that bond and replace it with the shortest-duration bond you can find.
We know that the longer a bond’s term to maturity, the more volatile its price will be.
We also know that the lower the coupon rate a bond has, the more volatile its price will be.
When you put those rules together, we arrive at some interesting conclusions. First of all, if interest rates are expected to fall, an active investor would position himself or herself into long-term, low-coupon bonds. And the longer the term, and the lower the coupon, the better, subject only to the investor’s risk tolerance.
Similarly, if interest rates are expected to rise, the ideal fixed-income holding would be a high-coupon, short-term bond. Our recommended corporate bonds are generally shorter-term issues. And some have very high coupons. This conservative stance serves to offset somewhat the non-systematic risk that corporate bonds present.
Universe gets smaller
But this also implies something else: no active investor will be very interested in either low-coupon short-term bonds, or in high-coupon long-term bonds.
This quickly reduces that huge universe of bonds, in terms of the number of issues outstanding, down to a select few only that are of interest to the bond trader. This simplifies matters significantly.
Seeking a middle ground
For the more passive buy-and-holder, however, or for the more risk intolerant, some middle ground is likely to be more palatable.
But then we run into a conundrum, because these rules work in opposite directions on bond price volatility. For example, as the coupon rate increases, the bond’s risk decreases. But as the term increases, risk increases. So what happens to your risk if you choose a bond with a higher coupon that also has a longer term?
To provide a more concrete example, suppose you narrow your choices down to either a seven-per-cent bond due in seven years, or a 10-per-cent bond due in 10 years, both rated AAA, and you want to choose the less risky of the two.
Is the seven-year bond less risky, because it has a shorter term? Or is the 10-per-cent bond less risky because it has a higher coupon? In short, which bond will fall less in price if interest rates should happen to spike upwards?
The simple answer is that you don’t know, because you don’t know at what point coupon risk becomes more powerful than term risk, or vice versa. Or at least you can’t tell by just looking at the bond’s coupon and term.
Duration solves the problem
The solution is to perform a calculation called duration. Duration is a formula invented by Frederick Macaulay back in the 1930s, that combines coupon risk and term risk into one number.
Duration is expressed in ‘years’, and the shorter the duration the less (coupon and term combined) risk the bond has. So a bond with a duration of 5.93 years, for example, will exhibit less price volatility when interest rates change than will a bond with a duration of 6.56 years, or in fact any bond with a duration longer than 5.93 years. Conversely, any bond with a duration of less than 5.93 years will show less price volatility.
Duration works proportionally, too. For example, a bond with a duration of 10 years will be twice as volatile as a bond with a duration of five years. Plus, if you invest half your money in a 10-year duration bond, and the other half in a five-year duration bond, the duration of your bond portfolio will be 7.5 years.
Bond selection simplified
Now, this really simplifies bond portfolio management. If you expect interest rates to fall, you simply find the bond with the longest duration, rather than sorting through a huge selection of terms and coupons. And then when you expect interest rates to rise, you’d sell that bond and replace it with the shortest-duration bond you can find.
So, how do you find out the duration of a bond? Unfortunately, you can’t just look it up in a newspaper or online, because it’s not a commonly published figure, probably because people don’t tend to know what it means. But now you do. So how do you get it?
The easiest way is to just calculate it yourself. That will be the subject of our next primer.
This is an edited version of an article that was originally published for subscribers in the May 28, 2021 issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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