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How the Market Works

How the Market Works: Bond Duration

Posted by kdadmin on March 10th, 2017.

How the Market Works: Bond Duration

Learning about bonds is like learning to use the brakes in your car. Would you drive a car without brakes? I wouldn’t. But building an investment portfolio without bonds is like doing exactly that. All motor, no control.

Think about how you use the brakes in your car. Do you slam them down every time you want to stop? Nope. That’s uncomfortable and dangerous. You likely take a much more moderate approach. In fact, over time, you learn how to feather them, when to coast, when to stop suddenly and even when to use the emergency brake. Bonds are the same way …

Macaulay Duration

The Achilles heel of the bond market is duration risk. “Duration” is short for Macaulay Duration. The calculation is shown above. And though I know at least a dozen of you can also do this math, I’m pretty sure you don’t want to.

The short story is that bond duration is a measure of sensitivity to interest rate changes. Which is a rather important thing in this time of arising Federal Fund rate.

Shades of Grey

While bond duration calculations are nowhere near as interesting as that film, there is a lot of teasing in the bond market, if you’re into that sort of thing. Here’s what I mean. Different types of bonds have different sensitivities to different things. The main factors are interest rate changes, treasury rates, the strength of the dollar, and erratic stock market behavior.

  1. Long term, high quality: More sensitive to interest rates, more to erratic stock market
  2. Short term, high quality: Less sensitive to interest rates, less to erratic stock market
  3. Long term, low quality: Less sensitive to interest rates, more to erratic stock market
  4. Short term, low quality: Less sensitive to interest rates, more to erratic stock market
  5. Foreign bonds add: More sensitivity to treasury rates, and the strength of the dollar.

To add to the complexity, interest rate changes are often dictated by Federal Reserve policy, specifically the Federal Funds rate, in an attempt to moderate or stimulate market pressure, and to avoid bad things like a market overheating (causing runaway inflation), a stalled market economy (stagflation), or an economy without growth (deflation). This is how the market works.

In other words, the Fed’s goal, essentially, is to foster a stable and even growing economic environment. To avoid the meteoric highs and brutal depression lows, that the market’s often lemming like behavior is prone to produce. One of their key data points is yield spread. You can learn more in my article, Yield Spread is More Useful Than You Think: How the Market Works.

More Bang for Your Buck

Of course, each of the bonds I listed above pay different interest rates, or generate different returns based on their type. The broad stroke rules are:

  1. Longer terms & lower quality = more default potential = more risk = higher returns
  2. Shorter terms & higher quality= less default potential = less risk = lower returns

Of course, this isn’t always true. For example, sometimes longer term, higher quality bonds can even outperform stocks. This happened in 2008 and 2009 when investors were fleeing stocks, globally, to the safety of long term treasury bonds.

Why Do You Care?

Knowing where we’re at the market cycle, especially as it relates to bonds is a crucial component of deciding which bond to use in your portfolio. Sometimes higher risks are worth it, sometimes not. It’s just like learning to use the brakes in your car. It takes a little finesse.

Of course, I don’t expect you to be able to calculate Macaulay Duration off the top of your head (if you could, maybe a trip to Las Vegas is warranted). But having a basic understanding of how different bonds respond to various market conditions can be incredibly useful in the erratic conditions we currently face.

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