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Bonds and duration risk

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With interest rates near record lows and nowhere to go but up in the long run, investors need to be aware of what may be in store for their bond portfolios down the road. In a MONEY TALK VIDEO, Dave Sandstrom explains that duration – or time until maturity – is a good way to judge bonds’ sensitivity to interest rate changes. Here is a transcript of the video:

In a low-interest rate environment, investors are very concerned about the yields in their bond portfolio.

The temptation exists to reach for yield by extending the duration in that bond portfolio. But investors need to be careful because extending that duration will expose you to additional risk in the value of those bonds, should interest rates suddenly rise.

There are a couple different definitions of durations used in the financial industry. The one I like to refer to is called modified duration. Modified duration works on the premise that interest rates and bond prices move in opposite directions. The calculation used to determine the duration will indicate to us how your bond value or the price of your bonds will react to a one percent change in interest rates.

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For example, let’s say that the duration in your bond portfolio right now is five years. This would tell us that for every one percent increase in interest rates, your bond portfolio will lose five percent of its value. Conversely, for every one percent decrease in interest rates, your bond portfolio would be expected to gain five percent in value.

So this relationship would suggest to us that in a time of declining interest rates, a longer duration is advantageous. Where in an environment where interest rates are rising, a shorter duration would be recommended.

Further information
Duration – What an Interest Rate Hike Could Do to Your Bond Portfolio, by the Financial Industry Regulatory Authority

When interest rates have been low for an extended period of time, and it looks like the future will hold an increase, establishing a bond portfolio with a low duration is an excellent way to defend against that increase and a loss of value in your bond portfolio.

Keep in mind that typically the lower the duration, the lower the yield. But we can’t forget the purpose of bonds in our portfolio: Safety and a hedge against the volatility of the equity markets.

Dave Sandstrom is a vice president and investment advisor at Landaas & Company.

Money Talk Video by Peter May
(initially posted April 26, 2013)

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