The other day, I wrote an article about Freddie Mac (NYSE:FRE) and Fannie Mae (NYSE:FNM). The article touched on derivatives used by Freddie to manage various types of interest rate risks, including duration. I thought it might be worthwhile to explore the concept of duration a little further.
The starting point for the discussion is to know that when interest rates go up, prices of bonds and bond funds tend to go down, and when rates go down, prices go up. Some types of bonds are more sensitive to rate increases than others. The textbook definition of duration is difficult to understand; duration is a weighted average of the time to payment of a bond's cash flows, where the weights are the relative present values of the corresponding cash flows. Whew! You need to be a real bond geek to understand what that means. A simpler way to think of it is that duration is a way to measure the price sensitivity of a bond to changes in interest rates.
Bond managers will use duration to increase returns in falling rate environments and reduce losses in periods of rising rates. Duration trading is a way for managers to try to provide alpha (alpha is the incremental return above a benchmark provided by active management).
Typically, bonds with shorter maturities have less price sensitivity (i.e., duration) to interest rate moves than longer dated bonds. Also, between bonds of like maturities, the bond with the lower coupon will have less duration.
A bond portfolio with the wrong duration could have its losses magnified as rates rise. Too much duration when rates are rising is akin to owning stocks on margin at the wrong time. To quantify this a little, a 1% rise in rates could be expected to cause an 8% drop in prices (this is a rule of thumb, and there can be many variables to cause different price action). Someone who has a portfolio of high coupon, longer dated bonds would likely take a bigger hit than 8% when rates rise by 1%. A portfolio of lower coupon, short dated bonds would likely have smaller price declines with the same market move.
I realize there is a lot of meat on this bone. The point here was to provide some basics. There are entire textbooks devoted to bond market mechanics and what influences pricing. The entire subject very quickly becomes more complex than equity markets and pricing models.
Fool contributor Roger Nusbaum is a portfolio manager and wildland firefighter in Prescott, Ariz. He owns no shares of any of the companies mentioned here.
