Duration: Introduction and its Implications
Duration of liability can be defined in more than one way. However, in actuarial valuation, duration of liability generally refers to the average duration (or mean term) of the liability. In other words, it refers to the average number of years at which a liability is paid off.
One of the ways it can be defined is as a measure of sensitivity of cash flows to its yield. At the same time, it measures the time taken to repay the bond’s price by bond’s present value of total cash flows to the investor.
FUNCTIONALITY OF DURATION
There are various fields where duration is getting a major importance in determining discount rates, it is not just the financial markets who are interested in valuation of duration, it has started to play a vital role in corporates in terms of valuing duration for as to set rates for gratuity funds, leave encasement funds and other employee benefit funds. Certain firms calculate the same rate for all of the schemes but it is more beneficial as well as factually correct to use different discount rates on the basis of their duration as every scheme holds a different liability for the firm, some actuaries even suggest using different rates for different employees.
In the context of actuarial valuation, we need to calculate duration to select the discount rate. The discount rate is based on the prevailing interest rates in the market, which vary by duration. Various accounting standards such as AS 15 (Accounting Standard 15) i.e. actuarial valuation for benefits of employees, Ind AS 19 (Indian Accounting Standard 19), IAS 19 (International Accounting Standard 19) and US GAAP require that the discount rate should be selected with reference to the duration of liability.
Coming to bond pricing, duration has proven to be one of the most reliable measures in the current scenario. We are very well aware of the fact that fixed income securities such as bonds’ prices have an inverse relationship with the interest rates. Higher the interest rate, lower is the price of bond. Now that we know that duration studies the intensity of the effect of change in interest rates, we can say that the higher the duration of a bond, the greater will be the change in the bond’s price. Generally, the higher a bond’s duration, the more its value will fall as interest rates rise, because when rates go up, bond values fall and vice versa. For instance, if an investor expects interest rates to fall during the course of the time the bond is held, a bond with a longer duration would be appealing because the bond’s value would increase more than comparable bonds with shorter durations.
The greater duration of the bond, the greater its percentage price volatility. By estimating the effect of certain market changes on a bond’s price, duration can help us choose investments that might better meet our future cash needs. Duration also helps income investors who want to take on minimal interest rate risk (that is, they believe interest rates might rise) understand why they should consider bonds with high coupon payments and shorter maturities.
As the table below shows, the shorter a bond’s duration, the less volatile it is likely to be. For example, a bond with a one-year duration would only lose 1% in value if rates were to rise by 1%. In contrast, a bond with a duration of 10 years would lose 10% if rates were to rise by that same 1%. Conversely, if rates fell by 1%, bonds with a longer duration would gain more while those with a shorter duration would gain less.
GAUGING INTEREST RATE SENSITIVITY
Bonds with longer durations experience greater value fluctuations.
Initial value of $1000
Source : The duration figures quoted do not relate to any specific PIIMCO Products.
Risk-averse investors, or those concerned about wide fluctuations in the principal value of their bond holdings, should consider a bond strategy with a very short duration. Investors who are more comfortable with these fluctuations, or who are confident that interest rates will fall, should look for a longer duration.
Duration is an important measure of a bond portfolio’s sensitivity to interest rate changes over time. Knowing the duration of a bond helps you compare bond opportunities, assess each bond’s risk, and select the right mix for your portfolio. Investors who want to capitalize on a trend of falling interest rates may purchase bonds with greater duration. Those who want to buy bonds during periods of interest rate volatility should look for bonds with low duration and high coupons. This minimizes their risk (low duration) and maximizes payments (high coupons).
USEFULNESS OF DURATION
DMT is one of the fundamental characteristics of a fixed- income security. Thinking of risk in terms of interest rates or yields is very useful because it helps in comparing otherwise very different securities
Because every bond and bond fund has a duration, those numbers can be a useful tool that financial professionals can use to compare bonds and bond funds while constructing and adjusting various investment portfolios.
If, for example, rates are expected to rise, it may make sense to focus on shorter-duration investments (in other words, those that have less interest-rate risk). Or, in this sort of environment, may want to focus on bonds that take on different types of risks, such as the Strategic Income Opportunities Fund, which is less affected by movements in interest rates.
While investing, two of the major risks that an investor considers are: fluctuation of price of securities due to change in interest rates and risk by the issuing party. Duration helps in quantifying both of these as they both impact the yield of the security.
Professionals dealing with financial market instruments usually tend to focus on duration of securities while investing long term. No doubt that it is considered in the short term as well but long term implies longer maturity ergo longer duration which makes it completely essential to study duration. While duration does have limitations, it can be an extremely useful tool for building bond portfolios and managing risk. As a portfolio manager’s interest rate outlook changes, he or she can adjust the portfolio’s average duration (by adjusting the holdings in the portfolio) to coincide with the forecast.
These adjustments can be made either for the portfolio as a whole or for a particular sector within the portfolio. For example, if the manager expects interest rates to fall, the average duration of the portfolio could be lengthened in order to get the maximum benefit from the change. On the other hand, if a manager’s outlook indicates that interest rates will be increasing, he or she could shorten the portfolio’s average duration, moving it closer to zero, to minimize the negative effect on values.
To summarize, in order to study DMT, we have to have complete knowledge of other factors such as coupon rate, yield to maturity, call provisions etc., so as to make a calculated decision. Duration should also be revised time to time because it could change due to external market factors to avoid surprises and work efficiently. Like other measures, it is not free of its limitations but continuous work on its calculation and theory is being taken out as to make it compatible with the present circumstances as well as the future possibilities.