You will be able to use duration to estimate how much a bond or bond fund's price changes when yields change.
Hui Min's friend Ravi told her that his bond fund fell about 7% in a year when rates rose by roughly one percentage point. Her own two-year bond barely moved over the same period, after the same rate rise. The difference comes down to a number called duration. Once you can read it, you can estimate how far a bond or bond fund's price will move when yields change.
Duration measures how sensitive a bond's price is to a change in yields. Fund factsheets usually quote it in a practical form: duration is roughly the percentage change in price for a one percentage point change in yield, in the opposite direction. If yields rise, the price falls by about the duration in percent for each point. If yields fall, the price rises by about the same amount.
A bond with a duration of 2 falls about 2% if yields rise one point, and rises about 2% if yields fall one point. A bond with a duration of 7 moves about 7% for each one point change. If a fund page says "duration 6.5 years", you can read that as about 6.5% of price per point of yield.
Duration comes in several versions. The one used for this estimate is often called modified duration. When you are reading factsheets, the difference between versions rarely matters.
Ravi's fund had a duration of around 7, so his fall matched the rule. On S$10,000, a duration of 7 means a fall of about S$700 if yields rise one point, and his statement showed that.
Two things make duration longer: a longer time to maturity and a lower coupon.
Maturity matters because of when the money comes back. A short bond returns most of its value soon, so a change in the discount rate has little time to affect it. A long bond's biggest payment is far in the future, and discounting over many years magnifies any change in the rate. Lesson 2.1, "Price and yield move in opposite directions", showed this. For example, take two made-up bonds, both with a 3% coupon, priced at 100, with yields at 3%. The two-year bond has a duration of about 1.9 and the ten-year bond has a duration of about 8.5.
The coupon matters because small coupons leave more of the bond's value in the final repayment, which is the payment furthest away. Take two made-up ten-year bonds with yields at 3%. A 1% coupon gives a duration of about 9.2, and a 5% coupon gives a duration of about 8.0.
As a rule of thumb, long, low-coupon bonds swing the most, and short bonds with healthy coupons swing the least. T-bills mature within a year and barely move with rates.
Find the stated duration on the factsheet, or on the broker or bank page. Multiply the duration by the change in yield in percentage points. Apply the result as a percentage price change in the opposite direction to the yield move. Multiply by the amount invested to get a money figure. For big yield moves, expect the actual fall to be a little smaller than the estimate.
Try it on a made-up eight-year bond with a 3% annual coupon, priced at 100, with yields at 3%. Its duration is about 7.0. If yields rise one point to 4%, the rule predicts a fall of about 7%, to roughly 93. Pricing the bond in full with the method from lesson 2.1 gives 93.27, a fall of 6.73%. If yields rise two points to 5%, the rule predicts a fall of about 14%. Full pricing gives 87.07, a fall of 12.93%.
The estimate is a little too pessimistic for big yield moves because the price curve bends: each extra point of yield knocks off slightly less than the point before. For everyday planning, the overestimate gives you a useful margin of safety.
A price fall only becomes a real loss if you sell at that price. If you hold a single bond to maturity and the issuer pays, you get face value back whatever rates did in between. This makes interest rate risk a timing risk. It hurts most when a rise in yields happens around the date you need the money.
Hui Min plans to use S$40,000 for a home down payment in two years. Suppose that money were in a fund with duration 7, and yields jumped one point the year before she needed it. She could be about S$2,800 short on the day. Her two-year bond has a duration under 2, so the same rise would cost her far less on paper. If she waited the few months to maturity, it would cost her nothing at all.
So start with the date you need the money, and keep the duration of what you hold shorter than the time until then. For a fixed date, consider instruments that mature on or before that date. A bond fund behaves differently from a single bond here. Lesson 7.1, "A bond fund never matures, and that changes everything", explains why.
You rarely need to calculate duration yourself. Bond fund and bond ETF factsheets usually state it, sometimes labelled "effective duration" or "modified duration". It is usually shown near the yield and the average credit rating. For single bonds, many broker and bank pages show duration next to the price.
Pick a factsheet for one bond fund or ETF and find its stated duration. Then use the rule above to estimate what would happen to its price if yields moved.
Find the stated duration on the factsheet of one bond fund or bond ETF. Estimate how much its price would change if yields rose by one percentage point, then by two.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).