Jargon Busting: Bond duration

Jargon Busting: Bond duration

This week’s column takes us into the clinical, mathematical world of bonds.

We leave behind the cosy warm furriness of equities and the statistical nonsense of fund analysis and plunge into the icy waters of bond valuations.

It’s time to break out the abacuses, the programmable calculators and spreadsheets. This is the utilitarian world of Dickens’s Bounderby and Gradgrind.

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When it comes to bonds, concepts such as ‘yield’, ‘coupon’, ‘maturity’ and ‘price’ are all intuitive and mostly jargon-free. But what about ‘duration’?

The word is readily bandied about and almost always adjectivally appended. A browse through the Investment Association bond sectors tells us duration may be ‘short’, ‘reduced’, ‘low’, ‘low average’, ‘long’, ‘ultra-long’ and even ‘hedged’.

This does not help very much.

With these descriptions, you could be forgiven for mistaking duration for a brand of margarine. An ultra-long or hedged butter substitute, however, is not so appetising.

We need to backtrack briefly to grasp what duration is not. And it is not maturity.

Maturity – the length of time until a bond is repaid – also appears in funds’ titles, but with the appendage ‘dated’. This term is paired with a much simpler set of adjectives: ‘short’, ‘medium’ and ‘long’.

Hence the M&G Short Dated Corporate Bond fund, for example, will invest in bonds that typically have less than five years to maturity.

So, do not confuse your short-dated with your short-duration. Ooooh no.

The concept of duration is quite simple, its calculation moderately complicated and multifarious, but, above all, it is misnamed.

Duration refers to the sensitivity of a bond to a change in interest rates. It is the calculation that tells us how much the price of a bond will move in response to a change in interest rates. Duration should, in fact, be more accurately named ‘sensitivity’.

This is genuinely useful information, verging on the compulsory. But it is easy to get lost in the detail.

There are lots of different types of duration – Macaulay duration, modified duration, effective duration…

This is where it starts to get tricky. The good news is that unless you are taking an exam, it doesn’t really matter.

Instead, we need to have an understanding of which types of bonds are most and least sensitive to changes in interest rates.

If you have a view that European quantitative easing will mean that yields are going to fall further, then you would want to own bonds with the highest or longest duration. That is, bonds with the greatest sensitivity to interest rates.

And vice versa: if you believe inflation is parked round the corner and is revving up its battle tanks, your bond exposure should be in low- or short-duration bonds.

Sparing the mathematical niceties, the rules of thumb are the lower the coupon and/or the longer the maturity of the bond, the greater the duration.