Understanding Duration

Duration is a significant component of debt funds. Economist Frederick Macaulay suggested duration as a way of determining the price volatility of bonds. The ‘Macaulay duration’ is the most common duration measure. It is also the basis on which all the duration funds under the Categorization and Rationalization of Mutual Fund Schemes as per Securities Exchange Board of India (SEBI) guidelines have been defined.

Duration is defined as the average time it takes to receive all the cash flows of a bond, weighted by the present value of each of the cash flows. Essentially, it is the payment-weighted point in time at which an investor can expect to recover their original investment. The importance of duration was experienced with the fluctuation in interest rates, because duration can help predict the likely change in the price of a bond given a change in interest rates.

Another important aspect of duration is that it allows for the effective comparison of bonds with different maturities and coupon rates. For example, a 5-year zero coupon bonds may be more sensitive to interest rate changes than a 7-year bond with a 6% coupon. By comparing the bonds’ durations, you may be able to anticipate the degree of price change in each bond assuming a given change in interest rates.

Upside of duration
Although no one can predict the future direction of interest rates, examining the ‘duration’ of different debt funds you own provides a good estimate of how sensitive your fixed income holdings are to a potential change in interest rates. Mutual fund managers rely on duration because it combines several bond characteristics such as maturity date and coupon payments into a single number that gives a good indication of how sensitive a bond's price is to interest rate changes. For example, if rates were to rise 1%, a bond or bond fund with a 5-year average duration would likely lose approximately 5% of its value.

Duration is expressed in terms of years, but one should not confuse it to be a bond’s maturity date. The maturity date of a bond is one of the key components in arriving at the duration, as is the bond’s coupon rate. For example, in case of a zero-coupon bond, the bond’s remaining time to its maturity date is equal to its duration. This way, when a coupon is added to the bond; the bond’s duration number will always be less than its maturity date. The larger the coupon, the shorter the duration number becomes.

As a general rule, for every 1% increase or decrease in interest rates, a bond’s price will change approximately 1% in the opposite direction for every year of duration. For example, in a bond with duration of 5 years, and interest rates increase by 1%, the bond’s price will decline by approximately 5%. Conversely, if a bond has duration of 5 years and interest rates fall by 1%, the bond’s price will increase by approximately 5%.

Generally, bonds with long maturities and low coupons have the longest durations. Such bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment. Conversely, bonds with shorter maturity dates or higher coupons will have shorter durations. Bonds with shorter durations are less sensitive to changing rates and thus are less volatile in a changing rate environment.

As an investor you need to keep in mind that duration is just one consideration when assessing risks related to your debt fund portfolio. Credit rating risk, inflation risk and liquidity risk are other relevant variables that should be part of your overall analysis and research when choosing your investments.

Disclaimers:

CRAMC has used information that is publicly available, and information developed in-house. The information gathered and material used above is believed to be from reliable sources. CRAMC however does not warrant the accuracy, reasonableness and/or completeness of any such information. While utmost care has been exercised while preparing this, CRAMC does not warrant the completeness or guarantee that the achieved computations are flawless and/or accurate and disclaims all liabilities, losses and damages arising out of the use or in respect of anything done in reliance of the above. The examples do not purport to represent the performance of any security or investments. In view of individual nature of tax consequences, each investor is advised to consult his/ her own professional tax advisor before taking any investment decision. The calculation shown, if any, are just examples and are only for illustration purposes, purely to explain the various concepts which are covered in the above. Please note the figures assumed above, if any, are purely for illustration purposes only & shall not be construed as indicative yields/returns of any of the Schemes of Canara Robeco Mutual Fund.