Bonds and interest rates have captured a lot of investor attention in recent weeks following the central banks move to put the brakes on inflation by raising interest rates.

Many investors, whether they are close to or in retirement rely on bonds to provide a stable income while others expect them to provide some protection to equity portfolios in times of market stress.

Last year bonds in aggregate lost money for investors while year to date they are down around 5%.

Bond prices are sensitive to the prevailing level of interest rates and bond duration is often used in that context, so if you are not sure what it means, this article explains what it is and how it applies your savings and investments.

Remember, bond yields move in the opposite direction to prices, so when yields rise bond prices fall and vice versa. But not all bonds fall or rise to the same extent, in other words, some bonds are more sensitive than others.

DURATION COMING TO THE FORE

That is where duration comes to the fore because duration is a measure of bond price sensitivity to a 1% change in interest rates.

As a rule of thumb, the longer the duration, the more sensitive the bond price is to a move in rates. For example, a bond with a duration of two years would be expected to fall 2% for every 1% rise in rates, while a bond with a 10-year duration would be expected to fall 10%, almost five times as much.

By the way, the same sensitivity works in reverse, that, is, when rates fall, the prices of longer duration bonds would be expected to go up more than those of shorter dated bonds.

Duration is a useful tool and effectively allows investors to manage interest rate risk in their portfolios. If investors expect interest rates to rise, they could act pre-emptively by reducing the effective duration of the portfolio.

One of the factors behind the poor performance of bonds over the last year is that, in aggregate, their duration has almost doubled over the last decade, from around six years to almost 10 years, until the recent sell-off.

This means as a whole bond markets have become almost twice as sensitive to rising interest rates, just as interest rate expectations have changed for the worse.

Perhaps not surprisingly, equities have also seen a significant rise in their duration, due in large part to the outperformance of growth and technology shares which are long duration assets. We will return to shares and how they are impacted by rising interest rates later in the article.

HIGHER DURATION EQUALS HIGHER RISK

Put simply, when you buy a shorter dated bond, you achieve your investment return sooner.

Longer dated bonds require you to wait longer to receive the expected return which puts you more at risk of adverse interest rate moves.

Think of it this way, if someone offered to sell you a two-year bond which had a coupon of 2% and you believed interest rates were going to increase, you would demand either a higher coupon to compensate you for the lost interest or a discount on the price.

The longer the maturity of the bond, (the longer you had to wait to receive you return) the bigger the discount you would demand and that is how the market works.

Bonds are valued by applying a discounted cash flow methodology which, as the name implies, involves discounting (reducing) future cash flows (interest payments) using an appropriate interest rate.

THE MECHANICS

An investor buys £1,000 worth of a five-year bond with a 2% coupon, i.e. it pays £20 a year in interest.

All future payments need to be discounted by the interest rate and in the example table we have used 2%.

In year one, £20 is divided by 1.02 which is £19.61. In year two the discount rate needs to take account of two years of 2% interest, so we multiply 1.02 by 1.02 to arrive at 1.04.

Therefore, in year two £20 is divided by 1.04 which is £19.22. This process is repeated for the number of years left for the bond and then the discounted payments are totalled to give a price of the bond.

As can be seen from the tables overleaf the longer the period to be discounted, the greater the impact on the theoretical value of the bond, making long-dated bonds more sensitive to interest rates.

There are other factors at play that influence the price of a bond, including liquidity and credit risk, but it is fair to say that for major government bonds, interest rate risk has the greater effect.

Although we have highlighted the risks of longer dated bonds in a rising interest rate environment, it shouldn’t be forgotten that you don’t have to sell a bond. After all, it is still paying you an income in line with what you expected when purchased.

You can hold to maturity when you are likely to get your principle back as well as the interest payments.

If interest rates come back down, over the life of the bond, it may not make a lot of difference to the return. One technical point to highlight is that duration is not the same as maturity.

Duration is calculated using the same discounted cash flow approach that we have discussed and can be thought of as the maturity of a bond adjusted for the average time weighted cash flows.

STOCKS ARE THE LONGEST DURATION ASSET
OF ALL

It is no surprise that technology and growth shares have seen the brunt of selling in stock markets as rising interest rate expectations have intensified.

We have shown that the further out in time that cash flows are expected to occur the more sensitive they are to rising interest rates.

Growth shares are priced to reflect strong growth and investors are implicitly not expecting to see some companies generate free cash flows or dividends for many years.

This means that the stock market and growth shares in particular are even more sensitive to rising interest rates than the longest dated bonds.

Shares has created a stream of cash flows from an imaginary company, Blue Sky Ltd which is expected to grow very quickly for several years. This is an extreme example designed to illustrate the principle.

Blue Sky’s cash flows have been discounted at a cost of equity of 5%, or in other words  investors should expect a minimum return of 5% to compensate them for the risks of holding the stock, to estimate the net present value of the cash flows and the implied value of the business.

What this exercise clearly shows is that growth stocks are ultra-sensitive to interest rates and they have had a significant tailwind for decades as rates have dropped.

It also underlines one factor which explains why so-called value shares have come back into favour, because they are often already generating cash and are not on such stretched valuations they are less sensitive to rising interest rates. As such they are considered low duration assets.

The US central bank has targeted peak interest rates of around 2.5% compared with the current Fed rate of 0.25%. A 2% increase in the cost of equity for Blue Sky would reduce its theoretical value by around 44%.

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