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Bond maturity and duration

By David Luhman on Sat, 05/09/2009 - 23:34

Bond maturity and duration

Duration vs. maturity

Because interest rate risk is perhaps your most important consideration in bond investing, and since interest rate risk increases with longer-term bonds, looking at the maturity date of a bond is one way to measure risk in bond investments.

But instead of looking only at maturity dates, many bond investors look at something called the duration of a bond to further quantify their interest rate risk.

Duration is always less than the maturity of a bond

The duration of a bond is related to the maturity of the bond, but the duration is always less than or equal to the maturity of a bond. The duration of a bond is a sort of weighted average of all the future payments offered by the bond.

Most bonds make interest payments during the life of the bond and then return their face value when the bond matures. The intervening interest payments are called coupon payments.

Coupon payments

Back in the good old days, when bonds were issued in paper bearer form and not electronically registered form, bond investors could claim their interest payments by clipping a coupon from the paper bond. This paper coupon was honored by banks like a check.

Computers and the IRS' desire to track interest payments put an end to paper coupons on bonds, but the terminology of "coupon payments" persists to this day.

High coupons reduce duration

Anyway, high coupon payments reduce the duration of a bond. Early repayment of principal, often called a sinking fund, also reduces a bond's duration.

So what's the big deal about a bond's duration? A bond's interest rate risk is proportional to its duration. Higher duration bonds face higher interest rate risk. Let's illustrate this with an example.

Take two bonds that both mature in 10 years. One makes semi-annual interest payments equal to the current market rate of 10 percent and repays its face value of $1,000 at maturity.

The other bond is sold initially at a deep discount to its face value. It makes no interest payments for 10 years, but at the end of 10 years it pays the full face value of $1,000. This is a so-called zero coupon bond and is similar to a US EE savings bond.

Because the first bond makes intervening coupon payments, it has a duration of about 6.5 years. The zero coupon bond has a duration of 10 years.

Because of its longer duration, the zero coupon bond is almost twice as sensitive to changes in interest rates as the first bond, although they both have the same maturity date.

It's easy to see why the coupon bond has lower interest rate risk.

Say interest rates suddenly increased. You could take the coupon payments from the first bond and reinvest them at the higher rate, thus cutting your losses. With the zero coupon bond, you're locked into the lower interest rate until the bond matures.

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