We Need to Talk About Duration (And a Lot More)
(Warning! This is a looonnng blog.)
If you own bonds (and if you have a retirement account, you probably do), you need to know what “duration” means. This is one of those words that means pretty much what you think it means. It refers to, in a roundabout way, how long it takes for a bond to mature. But it means so much more that that…
(A Side Note: When you buy a bond, you are making a loan. If all goes to plan, there will be a repayment of the amount borrowed (the principal) by the bond issuer when the loan comes due (the maturity date). Along the way, you collect regular interest payments, perhaps twice a year, at a stated interest rate. That is often called the “coupon.”)
When you buy a treasury bond, for example, the maturity may be five years. More realistically, you will buy a bond mutual fund or exchange traded fund, which is just a collection of bonds. The fund has a maturity date which is the average maturity date of all the individual bonds in the fund.
Duration, in plain English and somewhat over-simplified, refers to the length of time it will take you (the person buying the bond, e.g., making the loan) to get your money back. You might think that the duration then simply equals the maturity date, and you would be about 90% correct. But remember that while you must wait five years to get the big principal payment (if it’s a five-year bond), you were getting semi-annual interest payments in the meantime. Duration is a mathematical equation that takes those payments into account. Thus, the duration of a five-year bond is actually a bit less than five years. It’s more of a conceptual thing than an actual thing.
That’s kind of interesting but why should you care?
Duration tells us about the riskiness of a bond to changes in the overall economic environment.
Duration tells us how sensitive a bond’s price is to changes in interest rates in the economy.
To make a long story much shorter, the higher (longer) the duration of a bond (or bond fund), the more volatile the price of the bond (or the bond fund) will be.
Bond Prices and the Market Today
Let’s talk about what is happening in the market these days. For…reasons…many financial market participants believe that inflation will not drop as low as the Federal Reserve wants it to. Higher inflation means that a bond that you buy today, which pays you a fixed dollar amount of interest payments semi-annually, will be worth less in the coming years as those payments will buy fewer goods and services in the future.
Market participants also believe for…reasons…that the government will need to borrow more money in the future at a greater clip than it already does. They will need to sell more bonds. Even if you slept through Econ 101, surely you know that more supply of anything means the price will fall. More bonds? Each bond costs less. And in bond world, the way this is expressed is that the bond will pay a higher interest rate.
I’ll explain this next part without much math. If I buy a bond that pays an interest rate of 5% and matures in 10 years, I may be happy. But then (because of the reasons above), the government now starts offering bonds with an interest rate of 6%. Suddenly my old 5% bond does not look as attractive as the new kid on the block, and if I want to sell it, I am going to have to cut the price. Voila!Bond prices and interest rates move in opposite directions.
Now to make this next part easier, I need to explain some bond market lingo here. (You will thank me for it one day.) A bond that comes due (matures) more than 10 years from now is usually called a “long bond.” A bond (or bond fund) that has a maturity of between 2 and 10 years is called an “intermediate bond.”[i] Less than 2 years? That’s a “short bond.” You need to know these terms because when you buy a bond fund, these words generally appear in the title. They tell you what you are buying.
If I think that all those things are going to happen that conspire to drive interest rates higher, then I may still be willing to buy a short or intermediate bond (because they are not all going to happen overnight), but I may be reluctant to lock in what could prove to be a too-low interest rate for a long time. So, if you want to sell me a long bond today, you really need to cut the price to make it attractive to me.
And there you have it. The price of a long bond is more sensitive to what’s going on in the interest rate market/economy than a short bond. And duration is the mathematical formula that tells us exactly what that means in dollars and cents.
Precisely, a short bond fund with a duration of 2 years can be expected to change in price by about 2% if interest rates in the market change by 1%. A long bond fund with a 10-year duration will sink in price by about 10% if interest rates rise by 1%. (You bond geeks can play with this free duration calculator.)
Let’s put that complicated math story that I just told you to work. If you believe that interest rates will rise (or at least not fall) as many do, and you have absorbed the relationship that I described above between a bond’s maturity, its duration and how the price of the bond will respond to higher market interest rates, then you should arrive at the conclusion that a long bond fund is “riskier” than a short or intermediate bond fund. Here, “riskier” means that the price of the long bond fund is likely to fall further than the price of a short or intermediate bond fund as market interest rates rise.
Just as an example, in the month of July, Vanguard’s Long Term Bond Index Fund (VBLAX), with a duration of 13 years, dropped 3.8% in price. OTOH, their Total Bond Market ETF (BND), with a duration of 5.8 years, dropped only 1.2%. This is just a snapshot in time, but it illustrates the point.
How Bond Funds Work
Oh, but there’s more! Remember how I (sort of) explained how duration is calculated? In layperson’s terms, it’s how long it will take you to get your money back. If you have two identical 5-year bonds, one pays a 4% interest rate and the other 5%, which one has a shorter duration?
The 5% bond! Because the semi-annual interest payments are larger, you will get your money back quicker. Or think of it this way: If the issuer goes belly-up before maturity, you will have pocketed more money with the 5% bond than the 4% bond. Less risky, lower duration.
When you buy a bond fund, you are buying a vast collection of bonds. Literally, thousands. Every day some of the bonds are maturing and the proceeds must be used to buy more bonds for the pot. Now recall our story of rising interest rates and lower bond prices. As your bond fund replaces the old maturing bonds with cheaper bonds — and a cheaper bond has a higher interest rate as I explained earlier — the duration of the bond fund will fall. Your bond fund may actually become less risky (price less volatile) as interest rates rise. Whoaaaaaa…my head just exploded!
This was an exceptionally long piece, and I have not really told you what to do with all of this information. As I said at the top, it is highly likely that you own a bond fund. They appear in varying quantities in most diversified portfolios, such as retirement target date funds. And with good reason. Bonds act as a “shock absorber” in a portfolio that consists mostly of stocks.
Classically, the price of bonds rises when stock prices fall, but this inverse relationship has become more strained in recent years. Perhaps a better way to think of it is that bond prices will generally fall by less than stock prices when everything is going down (and you still get to pick up your semi-annual coupon payments regardless).
Think back to the dark market days of 2022. The price of the S&P 500 index dropped about 19%. The tech-heavy NASDAQ index lost a whopping 33% of value. But our aforementioned bond fund with the intermediate duration lost “only” 13% that year. I mean, that’s not great but it did its job. I do still believe that bonds have a place in your portfolio. But not just any bond fund…
I very much prefer intermediate bond funds; this is not at all a unique perspective. Even as 30-year treasury bond yields reached a 19-year high last month, I am not convinced that yields can’t go even higher over the coming years. (I am a child of the 70s. I’ve seen things.) Simply put, I’m a bit squeamish and I don’t like volatility; long bond funds give me the heebie-jeebies. I dunno; maybe long interest rates will eventually rise to a level that I feel compensates for the risk (i.e., bring the duration down enough to make the price less volatile). But I’m not a market timer so I prefer to hang out in the sleepier middle of the yield curve.
If you have made it to the end of this blog, I salute you. You have the patience of a long bond!
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[i] Okay, okay. To be technical about it, if we are talking about US treasury securities, it is called a “note” if the maturity is 2 to 10 years, and a “bill” if shorter than that.