Your Money: How duration of a bond determines its degree of price risk

Long duration bond funds, also referred to as targeted maturity bond funds in the US, pose a substantial degree of price risk.

By Sunil K Parameswaran

Bond duration is a key issue of interest to bond market investors. Duration is a measure of the price risk of a bond. The term ‘price risk’ refers to the risk that bond yields may move in an unfavourable direction, and have an adverse impact on the price of the bonds. If a trader is long in bonds, his worry is that market yields will rise, which will lead to a decline in the value of his portfolio. On the other hand, if a trader is short in bonds, his worry is that yields will fall, thereby pushing up the prices of the bonds which he has a commitment to buy. As investors know, bond prices and yields are inversely related.

Interest rate sensitivity
The duration of a bond is a measure of its interest rate sensitivity. For a given change in yield, the higher the duration the greater is the observed price change. Thus, bullish speculators who have bought bonds, and bearish speculators who have shorted bonds, will both look for high duration portfolios. If yields move as anticipated, they are likely to reap handsome profits. Of course, eventually one of them will lose substantially. Any bond which is traded before maturity, be it a plain vanilla coupon paying bond, or a zero-coupon bond, exposes the holder to price risk.

Conservative investors should go for low to moderate duration bonds funds, as these pose less price risk. New investors may believe that all bond funds are equally risky, and confidently invest, because they feel that debt is safer as an investment than equity. This is a fallacy. Long duration bond funds, also referred to as targeted maturity bond funds in the US, pose a substantial degree of price risk.

Debt mutual funds can be categorised by the duration of the underlying portfolio. At the lower end we have ultra-short duration and short duration bond funds. Then we have moderate duration bond funds as well as high duration bond funds. In the case of the latter two, capital gains can be substantial, as can capital losses.

Fixed maturity plans
Fixed maturity plans are an alternative from the standpoint of debt funds. In this case, the fund manager will hold the underlying portfolio till maturity. Since all the bonds are held till maturity, they are certain to pay the face value at maturity, unless of course the issuer defaults. It must be remembered that if a bond is held till maturity, there is no price risk, irrespective of interest rate movements in the interim, since all bonds will pay the face value at maturity. Fixed maturity plans are known as unit investment trusts in the US.

This does not mean that bonds which are held till maturity pose no risk at all. There is default risk, which applies to all bonds except government bonds. Also, when the coupons are received periodically, they must be reinvested. The risk that rates may be lower than anticipated, at the time of receipt of the coupons, is referred to as reinvestment risk.

All bonds with the exception of zero-coupon bonds, expose the holder to reinvestment risk. This is true even for coupon paying government bonds. Zero coupon bonds do not pose this kind of risk because there is nothing to reinvest. Hence if a zero-coupon bond is bought and held till maturity, the only risk is default risk.

The writer is CEO, Tarheel Consultancy Services