It is difficult to read a paper today or listen to a business news report without reference to interest rates going higher. So I thought I would review the main interest rate risk metric used by fixed income portfolio managers: Duration.

Interest Rate Risk Metric: Duration

If rates do go up, how much risk is an individual bond or portfolio exposed to? Duration will help measure this risk. Assume that a single bond has a duration of 4. If interest rates go up by 1.00%, then the bond is estimated to lose 4.00% of its price (technically the dirty price of the bond). A bond currently trading at the following theoretical prices 90, 100, and 110 would lose 3.6, 4.00 and 4.4 percent respectively. It is really that simple. If rates fell by 1.00% then the prices of the bond would move up by the same percentages.

Another measure of interest rate risk is dollar duration. Dollar duration is the same concept as above but instead of reporting the metric on percentages, it is reported in dollar amount. Using the same example as above the dollar durations are $3.60, $4.00 and $4.40.

The concept for a portfolio is the same. A portfolio with a duration of 5 would earn/lose 5% of its value for a 100 basis point move down/up, respectively.

Effective or option adjusted duration is similar in concept except the interest rate risk now takes into account the changes in the cash flows of the security. This is associated with agency mortgage backed securities and callable notes. The concept again is the same. An effective duration of 3 implies the note would gain or lose 3% of its value for a 100 basis point move. However, the challenge is that as rates go down, the note can be called or in the case of mortgages, individuals will opt to refinance their mortgages. The mortgage is prepaid at par and the callable notes may also be called at par. (Some callable notes will have a different call price than par.) Therefore, a note’s price with this option embedded feature will compress as rates start to fall below the call rate or where the individual thinks it is profitable to refinance their mortgage. If rates do move higher, prepayments in MBS should go lower. Callable bonds will not be called.

Duration and Portfolio Management

In a rising interest rate environment, a portfolio manager would want to lower their portfolio’s duration. For example, if the portfolio’s duration is currently 6, the portfolio manager may target a duration of 3. If the portfolio manager is being judged against a benchmark/index, then the portfolio manager would want to have a duration that is lower than that of the benchmark. For instance, assuming the duration for the benchmark/index is 5, the portfolio manager might target a duration of 4. If rates do rise, the attribution analysis will show that the portfolio manager outperformed the index. At least for the interest rate component!

Lastly, fixed income portfolios will own notes and bonds over a variety of maturities. The duration can be calculated at predetermined maturities such as 2, 4, 6, 8 and 10 years. If the portfolio has longer maturities, then additional periods can be added. These time periods are commonly known as gaps or buckets. Calculating the duration for these gaps is known as key rate duration or partial duration. This allows the portfolio manager to manage yield curve risk.

The Bottom Line on Duration

Whether you are involved with asset liability management at a bank, insurance company or as an asset manager, duration is a key metric to manage interest risk. To learn more, refer to our course descriptions for training on interest rate risk, duration and asset liability management.

Author

  • Ken Kapner

    Ken Kapner, CEO and President, started Global Financial Markets Institute, Inc. (GFMI) a NASBA certified financial learning and consulting boutique, in 1998. For over two decades, Ken has designed, developed and delivered custom instructor led training courses for a variety of clients including most Federal Government Regulators, Asset Managers, Banks, and Insurance Companies as well as a variety of support functions for these clients. Ken is well-versed in most aspects of the Capital Markets. His specific areas of expertise include derivative products, risk management, foreign exchange, fixed income, structured finance, and portfolio management.