Question: Explain the concept of duration and then comment on the statement, “it is possible that a bond with a shorter maturity than another bond may actually have a longer duration and be more price sensitive to interest rate changes.
We will write a custom Essay on Concept of Bond Duration specifically for you
301 certified writers online
Explain why a bond with a shorter maturity than another bond could have a longer duration; use examples
When investing in bonds, the measure of risk that is commonly used is the bond duration. In this case, a single number is used in depicting call features, final maturity, coupon and the expected yield of a bond. Hence, the concept of bond duration attempts to point out the degree of price sensitivity over a given period.
This implies that when there is a change in interest rate with the passage of time, it directly affects the yield margin or profitability of a portfolio or bond (DeCosta, Leng & Noronha, 2013). As a result, portfolio managers have to be very keen when floating their bonds into the market.
Duration can be computed using a number of methods. Nonetheless, it is vital to note that the most common term used is effective duration. It refers to bond duration over a given time. This duration may be short, medium or long term.
When the price of a security changes and then it is calculated as a percentage, it is referred to as effective duration. As already hinted out, this change also affects the yield or return of a bond.
For instance, the value of a bond or portfolio that has an effective duration of 3 years is anticipated to either increase or decline in market price with a margin of 3 percentage points. On the same note, a bond with an effective duration of ten years may either improve or weaken in value by a margin of ten percent.
The latter scenario is possible because bond yield is supposed to get better after a given period. In any case, maximum returns are only possible for long-term bonds.
Various situations also demand different methodologies for estimating the duration of a bond. This implies that different interest-rate scenarios influence changes in bond portfolios. Some of the common measurement of duration include total curve duration, spread duration, curve duration, bull duration and the bear duration.
On the other hand, the time taken by a bond portfolio to remain relevant is usually referred to as maturity. After the cessation of a financial instrument, the maturity level ends. The principal sum should then be repaid together with interest earned. This finite period indicates the maturity of a portfolio (DeCosta, Leng & Noronha, 2013).
It is indeed true that a bond with shorter maturity may have a longer duration. It may also witness significant changes when it comes to interest rates. When other external and internal market factors are kept constant, higher interest rates are accrued from bonds with longer maturities.
It is crucial to mention that a greater risk is carried by a bond with a longer duration. In other words, long-term bonds stand the risk of being affected by market forces such as inflation and changes in government policies. As a result, the payment values received from such bonds may decline against the expectations of investors.
The price of such long-term bonds can easily fall owing to the glaring risks in the market. The latter are more profitable than short-term portfolios. From the outset, it is evident that bonds with short maturities do not yield optimum benefits to investors.
Even if specific bonds are slated for short-term maturities, a very limited number of investors may be willing to release them out for trading. Even though the degree of risk increases with the time taken for a bond to mature, most investors are often ready to risk their investments for the sake of reaping higher returns.
Get your first paper with 15% OFF
In any case, markets can hardly be free from financial challenges even if investors rush for short-term bonds.
Portfolios that mature after a very short time tend to lock investors’ money. In addition, investors earn meager returns in such bonds. This expounds why liquidity risk is a major threat for investors who are keen in reaping maximum returns from the market.
The latter scenario also elaborates the reason why a bond with a shorter maturity might as well take quite a long duration before it is eventually released into the market for trading. For example, in the case of short-maturity bonds, there is minimal fluctuation of the dollar prices of the portfolios.
In this regard, an investment that is not in tandem with inflation is common in finances ploughed back for long-term bonds (Leibowitz, Bova & Kogelman, 2014). It is also a market tactic to extend the lifetime of bonds with short-term maturities.
For example, the monetary policy is often signaled by the Federal Reserve to act appropriately according to the changes in market demands. When the prevailing market conditions are restrictive, the Federal Reserve may institute strict measures that can consequently alter the behavior of professional portfolio managers.
Hence, the shortest maturities can be bought after selling the long bonds. Thereafter, matured bonds may be reinvested using the short maturities (Ajlouni, 2012).
Such an arrangement can easily lead to a situation whereby bonds with shorter maturities extend for a longer duration in the market contrary to the expectations of traders. The latter depends on the changes in interest rates.
Ajlouni, M. M. (2012). Properties and limitations of duration as a measure of time structure of bond and interest rate risk. International Journal of Economic Perspectives, 6(4), 46-56.
DeCosta, D., Leng, F., & Noronha, G. (2013). Minimum maturity rules: The cost of selling bonds before their time. Financial Analysts Journal, 69(3), 45-56.
Leibowitz, M. L., Bova, A., & Kogelman, S. (2014). Long-term bond returns under duration targeting. Financial Analysts Journal, 70(1), 31-51.