Bonds explained: part 3

Bonds form a significant part of many investment portfolios and can often make up the majority of holdings in some lower risk portfolios, yet many investors know little about them.

At Schroders Personal Wealth we believe it’s important for people to be as informed as possible about the investments they hold. So we have written a three-part educational series that explains bonds in as simple language as possible.

The series is written in a Q&A format and attempts to cut through the jargon to help you understand what bonds are and how they work. This third part builds on Parts 1 and 2 and covers something called bond duration.

The terminology here gets quite confusing, so it’s worth noting at the outset that when people talk about ‘long duration bonds’ they mean bonds with long times to maturity. And when they talk about ‘short duration bonds’ they mean bonds with short times to maturity.

Similarly, when someone talks about ‘duration risk’ they are referring to the impact a change in interest rates could have on a bond or bonds. And when people talk about having ‘duration’ in their portfolio, they mean they hold bonds that are sensitive to interest rate changes.

You may benefit from rereading Part 3 until the concepts become clear. This may not be easy but we hope it will be rewarding. After all, understanding bonds is an achievement in itself. So why not just take a deep breath and go for it!

Good luck and happy learning!

Last time you outlined why some bonds are riskier than others, and we also considered bond spreads and yield curves. Could you now tell me whether all bonds are affected by interest rate changes to the same degree.

No, they’re not. ‘High duration’ bonds have a high sensitivity to interest changes, but ‘low duration’ bonds have a lower sensitivity to interest rate changes.

So, if interest rates rose, a high duration bond would see a greater fall in price than a low duration bond?

In general, yes.

What, then, determines whether a bond’s duration is high or low?

There are two key factors: a bond’s time to maturity and its yield. Generally speaking, the longer a bond’s time to maturity, the greater its sensitivity to actual and expected interest rate changes and the higher its duration. And the higher a bond’s yield, the lower its sensitivity to these changes and the lower its duration.

Why are bonds with longer times to maturity more sensitive to actual and expected interest rate changes?

First, there’s a greater probability interest rates will change in a longer time period than in a shorter period. Second, the longer the time period, the greater the number of interest payments that will be affected by any interest rate changes.

Can you explain the second point please?

Sure! Let’s go back to our example at the start of part 1 of this series. You have a UK government bond (gilt) paying 5 percent annual interest at a time when the rate of interest from the Bank of England and from bank savings accounts is also 5 percent. You decide to sell your bond, but just before you do so the rate from the Bank of England and from bank savings accounts rises to 6 percent.

In this example, a one-year gilt with only one interest payment left until maturity would underpay a prospective buyer of your bond by 1 percent for only one interest payment. But a 10-year gilt with 10 interest payments left would underpay that prospective investor for a much longer period. This difference in remaining payments would cause a greater drop in the 10-year gilt’s price than the one-year gilt’s price when the interest rate rises. So the longer dated gilt is more sensitive to interest rates changes than the shorter dated gilt.

Thanks! Could you please now explain why bonds with higher interest payments are generally less sensitive to interest rate changes than those with lower interest payments

Certainly. Their higher interest payments mean investors receive a higher share of their overall bond returns early on in the term of the bond. So they are less affected by subsequent interest rate changes than bonds with lower interest rate payments.

But there’s a caveat here. Companies issuing high yielding bonds are generally higher risk and can struggle if an economy weakens. Since rising interest rates can hinder economic growth they can also increase the chances of companies issuing high yield bonds going into default. Against this backdrop, their bond prices have the potential to fall significantly if interest rates rise.

I’ve now got a good overall idea of how bonds work. Is there anything else I should know?

Yes there is: the word ‘duration’ has two different meanings. You need to be aware of these to avoid confusion.

I’ve so far used duration to refer to a bond’s sensitivity to interest rate changes. This kind of duration has the full title of ‘modified duration’.

But there’s another kind of duration, which has the full title of ‘Macaulay duration’. Macaulay duration estimates how many years it will take for an investor to be repaid the price they paid for the bond in terms of interest payments and capital repayment.

It sounds like ‘time to maturity’!

You’d be forgiven for thinking that. The fact that Macaulay duration is measured in years of payback does make it sound like time to maturity, which adds a further layer of confusion! And in many cases Macaulay duration and time to maturity are not vastly different.

The key things to note are that, all things being equal, Macaulay duration is higher for bonds with longer times to maturity and is lower for bonds with higher coupon payments.

Crucially, a bond’s Macaulay duration decreases when interest rates go up. And through an extra layer of calculation you can estimate the bond’s modified duration – its sensitivity to interest rate changes – that I’ve already mentioned.

So if Macaulay duration is measured in terms of years, what’s the measurement for modified duration?

Good question! Modified duration measures the percentage change in the value of a bond due to a 100 basis point (1 percent) interest rate change. A bond with a modified duration of 3 percent would fall by 3 percent if there was a 1 percent rise in the interest rate. And it would rise by 3 percent if there was a 1 percent fall in the interest rate.

But the modified duration for a particular bond could be different for a 100 basis point interest rate rise from 5 percent to 6 percent than for a 100 basis point rise from 6 percent to 7 percent. And it changes during a bond’s onward march towards its maturity date.

See, I said bonds were complex!

Agreed. But few of us need to know all this detail. The main points are that, when people talk about ‘long duration bonds’ they mean bonds with long times to maturity. And when they talk about ‘short duration bonds’ they mean bonds with short times to maturity.

But when someone talks about ‘duration risk’ they are referring to the impact a change in interest rates could have on a bond or bonds. And when people talk about having ‘duration’ in their portfolio, they mean they hold bonds that are sensitive to interest rate changes.

In the end, though, as I said at the start of part 1, a bond is just a loan for a specific period of time that provides a series of interest payments. But it’s a loan that’s traded on the stock market.

Thank you for explaining all this. I now think I’ve got the bones of bonds…