Creating a Financial Plan
Duration varies with maturity, which is the time period after which a bond ceases to exist, and an investor is repaid their initial investment (that is, the principal, or bond’s face value). Bonds of shorter maturity tend to have a lower duration, meaning their value is less sensitive to interest rate moves. On the other hand, longer maturity bonds typically have greater durations. So, compared to a shorter maturity bond, the value of a longer maturity bond will tend to experience more of a decline for a given percentage increase in interest rates.
To better understand duration (which, because of the way bond math works, is specified in years, but should not be confused with the maturity of the bond), let’s consider some hypothetical examples. For simplicity’s sake, we’ll focus purely on the impact of interest rates and ignore any other possible influences on a bond’s price.
The price of a bond with a duration of five years will decline about 5% for every percentage point increase in the prevailing market interest rate for bonds of similar maturity. Meanwhile, the price of a different bond with a greater duration would experience a greater decline: for instance, the value of a bond with a duration of 6.5 years will decline by roughly 6.5% for every percentage point change in interest rate.
The relationship between price, duration and interest rates is, however, only an approximation. As a bond “ages,” it moves closer to maturity and, by definition, its duration will change. What’s more, as a bond’s price changes, this also affects duration.
One way in which active managers can seek to manage exposure to interest rates is by adjusting the overall duration of their bond portfolios. For example, if they expect prevailing interest rates to trend higher, active managers could seek to limit near-term losses by investing more heavily in bonds of shorter maturity (which tend to have shorter duration). Duration positioning is just one of the ways in which active managers can seek to add value and generate returns for bond fund investors that outpace the broader market.
Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing.