Today I want to expand on my previous article about the relationship between interest rates and bond prices.
You should now be well aware that interest rates and bond prices move in opposition. When rates fall, bond prices increase. And when rates increase, bond prices fall.
But how big is the effect? To predict that, you’ll need to familiarize yourself with a concept known as the “duration” of your investment.
Duration? What’s that, you ask? Well… It’s a bit complicated, but can generally be defined as follows:
The duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received. (Source: Wikipedia)
In other words, the duration is essentially a measure of how long your money is tied up. Shorter maturities and higher yields both reduce the duration of your holdings. And yes, you should be able to simply look up the duration in most cases.
Importantly, the duration is also a measure of price sensitivity to interest rate changes. In short, when interest rates change by a certain percent, you can expect your bond’s value to move that percent times the duration in the other direction.
Take, for example, Vanguard’s Total Bond Market Index Fund (VBMFX/VBTLX). As of now, that fund has an average duration of 5.5 years. So if interest rates increase 1%, you’d expect the fund’s value to decrease by 5.5% — pretty simple, right?
Given that longer maturities tend to increase duration, it should be clear that longer-term bonds will tend to have greater price sensitivity. They’ll be punished more severely by rate increases and rewarded more richly by rate decreases.
Another useful tidbit is that, if rates raise (and thus bond prices fall), the duration gives you an idea of your break-even point if you hang on to your investment and continue to reinvest the dividends.
Let’s say interest rates jump 2%. The value of the fund above will decrease ca. 11%. But it’s yield will increase, and your reinvestments will thus buy these higher yielding shares. Over time, the loss in value will be offset by dividends earned.
So, in effect, the duration gives you an idea of the appropriate time horizon for a given investment. If you might need the money in less than 5.5 years, then perhaps the fund above isn’t right for you — unless you have a crystal ball, of course. 😉