Risk & Allocation
What Duration Tells You About A Bond Fund
Duration expresses how sensitive a bond holding is to a change in interest rates, and it explains why two funds holding similar credits behave very differently.
Two bond funds can hold debt of similar quality and respond quite differently to the same move in interest rates. The number that describes the difference is duration.
A bond's price and prevailing rates move in opposite directions
A bond promises fixed payments on a schedule. If newly issued debt starts offering more, the existing promise becomes less attractive and its market price falls to compensate.
The reverse holds when new issuance offers less. An existing bond paying more than current terms becomes worth more than its face amount to a buyer.
Nothing about the issuer has changed in either case. The movement comes from the comparison with alternatives available now.
Duration measures how large that response is
Duration is expressed in years but functions as a sensitivity measure. It approximates how much a bond's price moves for a given change in yields.
Longer duration means a larger response in both directions. A holding with roughly twice the duration of another will tend to move about twice as far for the same rate change.
The measure is an approximation that works best for modest changes, and it becomes less accurate for large moves because the relationship is not a straight line.
What makes duration long or short
Time to maturity is the main driver. Payments due further away are affected more by discounting than payments due soon.
The size and timing of interim payments matter too. A bond paying substantial income along the way returns value earlier, which shortens duration relative to maturity.
A fund's duration is a weighted figure for the whole portfolio, published in its materials and updated as holdings change.
Funds do not mature, which changes the experience
An individual bond held to maturity repays its face amount, so an interim price decline reverses as the repayment date approaches, absent default.
A fund holding many bonds continuously replaces maturing positions to maintain its stated profile, so there is no date on which the portfolio pays back a fixed sum.
What a fund holder gets instead is a changing income stream. As older holdings mature and new ones are bought, the portfolio's income reflects current conditions rather than past ones.
Duration describes rate sensitivity and nothing else
It says nothing about whether an issuer will pay. That is credit risk, measured differently and driven by different conditions.
It also says nothing about direction. A long-duration fund is not a prediction that rates will fall; it is a statement about how large the response will be either way.
Matching duration to the horizon over which money is needed is the usual reason the measure appears in allocation decisions, since sensitivity matters most when a sale is not optional.
Questions readers ask
Is a target date fund a good default?
For somebody who would otherwise never adjust anything, it does a job that would not otherwise get done. It is weaker where a lot of your wealth sits outside it.
What does to versus through mean?
Whether the fund stops adjusting at the target date or continues reducing risk for years afterwards. The two produce quite different allocations on the day you retire.
