Investors who simply intend to hold a bond until maturity will have little concern for its duration, but investors who may wish to resell the bond before maturity or whose decision-making is affected by their current portfolio value will be interested in a bond’s duration.
Duration is a complex measure involving a bond’s yield, present value, coupon rate, call features and maturity date. Fortunately a bond’s duration is a common feature in any fixed-income data set, and traders do not need to calculate each bond’s duration for themselves.
To give a rough sense of how duration works, imagine two different bonds with the same coupon rate, but different maturities: 3 years and 5 years.
An increase in interest rates of 1% would mean that the 3 year bond would forego 3% in lost value (3 years of missing the 1% increase in interest rates), while the 5 year bond would forego 5% in lost value.
This same principle underpins the more complex calculation used to measure a bond’s duration. Duration is measured in the additional years of holding the bond that it would take to compensate for the lost value caused by an increase in interest rates.
Bonds with a shorter period until maturity will tend to have a smaller duration to reflect their decreased exposure to interest rate changes over a shorter period of time, while longer dated bonds will have a higher duration to reflect their greater exposure to interest rate changes as a result of their longer time until maturity.
Duration and Trading
Day traders will often be interested in the duration of bonds that they intend to trade because they will be looking to trade on the volatility associated with shifting interest rates, whether as the direct result of central bank decisions or the more nuanced shifts in various interest rates caused by factors such as perceived risk and economic performance.
A bond’s duration is an excellent indicator to use when sorting bonds based on their potential volatility resulting from a forecasted interest rate change.
Day traders can then focus their analytical efforts on those bonds that are most likely to react strongly to the forecasted change in interest rates without needing to analyze the coupon and term structure of each individual bond.
On the other hand, duration is a poor indicator when it comes to forecasting the actual price action that a day trader will use to make actual trading decisions. In this sense, duration is more suited for use by investors, who are looking at much longer time frames and building portfolios that spread their risk across asset classes and periods of time.
Duration is an extremely useful sorting measure that any day trader who trades in fixed-income should become accustomed to using.
While duration is generally not useful for making actual trading decisions across the time frames that day traders typically deal in, it is useful for identifying those bonds that are worthy of further analysis.