Many fund managers are taking short duration bonds to manage risk and enhance performance believing that yields have nowhere to go but up. So how does duration affect the risk and performance of a bond portfolio? Lets first define and quantify what is meant by duration and how it is applied.
Duration is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. It is an important measure for investors to consider, as bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations.
For the two most basic types of bonds the duration calculation varies: a zero-coupon bond has duration that is equal to its time to maturity; a bond that pays a coupon will always have a duration that is less than its time to maturity.
Thus on a zero-coupon bond the entire cash flow occurs at maturity, while a bond that pays coupons yearly and matures in, five or ten years will conversely repay the amount paid for the bond sooner.
Duration can also be used as a measurement of a bond portfolio’s sensitivity to interest rate movement in response to expectations that stronger economic activity will fan inflation, eroding returns on securities that pay fixed rates of interest. Enables IFA’s are always able to help you understand how to make the best of the bonds you hold in your portfolio.
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