What is duration and how is it used?
So far, we have seen how bond prices move in relation to interest rates. However, how can we know how much a bond’s price will change in response to a move in interest rates?
This is where duration comes in. Duration is used to measure the sensitivity of a bond’s price to changes in interest rates and tells us the approximate change in the price of a bond in the event of a 1% change in interest rates. Duration is stated in years. For example, a two-year duration means that the bond will decrease in value by approximately 2% if interest rates rise by 1%,and increase in value by 2% if interest rates fall by 1%, holding other things constant.
As the table below shows, bond prices are impacted by interest rate changes - bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations.
In other words, duration can be an indicator of how risky (in terms of interest rate risks) a bond is. For example, if you are not risk averse and think that interest rates are going down, you should buy a bond with a longer duration, so that you will benefit more from a fall in interest rates compared to a shorter duration bond. Conversely, should your view be wrong and interest rates increase instead, you would suffer a greater loss.
Bond yield and time to maturity
The yield curve is the relationship between the interest rate and the time to maturity of the debt for a given borrower in a given currency. It is drawn by plotting yields, or interest rates, of bonds against time. The slope of the yield curve can help with predicting future interest rate changes and economic activity.
Generally speaking, yield curves can be broadly classified into three main types:
1) Normal Yield Curve
Yield curves are usually upward sloping, meaning the longer the maturity, the higher the return (yield). A longer-term bond usually involves more risk that the borrower will default, or interest rates will change, or the lender will find a better potential use for their money. Investors therefore demand greater compensation for the uncertainty over a longer time period, also known as term premium. Generally, a normal yield curve implies stable economic conditions and a normal economic cycle.
2) Inverted yield curve
An inverted yield curve arises when short term interest rates are high relative to long-term expectations. This curve indicates that investors expect interest rates to be lower in the future. Term premium in this instance is negative. Such a yield curve corresponds to periods of economic recession, where investors expect yields on longer-maturity bonds to trend lower in the future.
3) Flat yield curve
This curve indicates the yields of bonds with different maturities are relatively constant, and is seen when interest rates are expected to decline moderately but offset by positive term premium. A flat yield curve reflects similar yields across all maturities, implying an uncertain economic situation.
