A Tale of Duration

“Just Learn the Rule of Thumb”

What do you mean?  Is it really?  Are you sure?  These are common phrases frequently used when we simply don’t understand something.  I’m sure we all have our unique ways to express our bewilderment.  Duration is a financial term that applies to bonds that falls in the bewilderment category.  If you ever want to learn about something boring and arcane, take duration up as an interest.  That is a bond joke in case you missed it.  If you do, you will be right alongside bond traders but for personal investing—-there is only one thing that matters about duration and I will teach you the rule of thumb.  It’s worth learning.

Here is the rule and we can come back to it.  The rule is meant to answer the following question.  What happens to the value of my bond if interest rates go up or down 1%?  The answer is surprisingly simple.  If the duration of your bond is 5 years and rates go up 1% you lose 5%.  If they go down 1% you make 5%.  If the duration of your bond is 20 years and rates go up 1% you lose 20%.  If they go down 1% you make 20%.

If rates go up 1% I will lose an amount equal to the duration of my bond holding.  If they go down 1% I will make an amount equal to my bond holding.  This means the longer the duration, the more volatile the price of the bond.

When asked, what happens to my bonds when interest rates go up.  The answer starts by asking the question—when do your bonds mature.  From there we can calculate duration and once we know duration, we can provide a very precise answer.  The following tables are based on US Government bond prices as of June 28, 2018.  It’s amazing just how accurate this rule of thumb actually is.

 

Interest Price at
Current Rate Higher
Interest Current Increases Interest Change
Duration Rate Price by 1% Rate in Value
5 2.73%  $  874.00 3.73%  $  832.68 -4.73%
10 2.83%  $  756.49 3.83%  $  686.70 -9.23%
20 2.91%  $  563.44 3.91%  $  464.36 -17.58%
30 2.97%  $  415.60 3.97%  $  311.00 -25.17%

 

Our rule of thumb predicts that a 1% rise in interest rates will watch the 5-year duration bond drop 5% and it actually drops 4.73%.  Not too shabby.  It predicts a 10% drop for the 10 year and we observe a 9.23% drop.  The close approximations hold true for the 20 and 30-year durations as well.  This is a good rule of thumb or heuristic.  Let’s see what happens if rates go down 1% as shown in the following table.

 

Interest Price at
Current Rate Lower
Interest Current Decreases Interest Change
Duration Rate Price by 1% Rate in Value
5 2.73%  $  874.00 1.73%  $  917.81 5.01%
10 2.83%  $  756.49 1.83%  $  834.15 10.27%
20 2.91%  $  563.44 1.91%  $  684.96 21.57%
30 2.97%  $  415.60 1.97%  $  556.96 34.01%

 

As we can see from this table, if rates go down 1% the rule of thumb works as well and maybe a little better.  In any event, this is a very good rule to keep in your back pocket when analyzing interest rate scenarios.

For those that want to get deeper into an understanding of duration, my advice is—don’t’ do it.  But if you are compelled to learn all you can the following link is a good place to start.  Just remember one thing though, the root of the word duration is “hard” which means it isn’t easy for most people to understand and quite frankly, will not make you any wealthier unless you want to become a professional bond trader.  But the lesson that longer term bonds are more volatile than shorter term bonds is a lesson we should all know and learn.  May your life be easy.

https://www.investopedia.com/terms/d/duration.asp

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