With interest rates on the rise, you might be wondering if you should be worried about the value of your bond portfolio. Duration and a closely-related measure called convexity can help you find out…
Over the past six months, the benchmark rate on the 10-year Treasury note has risen from 1.4% to 2.4%. When interest rates rise, bond prices fall (and vice versa). How much a particular bond’s price falls depends on two major factors: how much rates rise and the duration of the bond.
Duration measures how sensitive a bond’s price is to changes in interest rates. The higher the duration, the higher the sensitivity. If a bond you own has a duration of 4 and rates go up by 1%, its price will drop by approximately 4%. If a bond I own has a duration of 6 and rates go up by 1%, its price will drop by approximately 6%.
It’s important to note that a drop in your bond’s price caused by a rise in interest rates isn’t all bad news. Why is that the case? The interest that the bond pays you at regular intervals (usually semiannually) can be reinvested at the new higher interest rate.
There are a number of bond characteristics that can affect its duration. One such characteristic is the maturity of the bond. As the maturity of the bond increases, its duration also increases. Another characteristic is the coupon rate of the bond. As the coupon rate increases, the duration of the bond decreases (and vice versa).
If duration is the bond-pricing Batman, then convexity would almost certainly play the part of Robin. Oftentimes, duration alone isn’t enough to completely capture bond price movements caused by changes in interest rates. In these cases, a convexity adjustment is used to fine-tune the price change estimate produced by duration alone.
Convexity is a favorable characteristic for a bond to have. It causes the bond’s price to fall more slowly when interest rates rise and rise more quickly when interest rates fall. As such, I highly recommend it!
This has been a very brief conceptual overview of bond duration and convexity. Financial theory on the topics can get rather rigorous if you’re so inclined. As always, if you have any questions about anything I’ve written here, please don’t hesitate to get in touch!
Note: This article was adapted from a presentation given to College for Financial Planning faculty members on February 7, 2017.
Brian Littlejohn is the Founder and CEO of Sherwood Investment Management, a fee-only financial advisor firm in Sonoma County, California. Brian is a CERTIFIED FINANCIAL PLANNERTM professional who specializes in investment management. He holds a MBA and a Master’s Degree in Financial Analysis. He has over a decade of experience helping clients achieve their financial goals and occasionally teaches investing and financial planning courses as an adjunct professor.