A bond is a security which can be purchased by private as well as institutional investors. A certain term (maturity term) is set and the bond has to be repaid once the bond matures. Interests are usually paid at regular intervals (quarterly, semi-annually or annually) during its maturity term. The extent of these interest payments are generally specified in advance, which is why bonds are also referred to as Fixed Income securities.
By contrast, the rates and thus the prices and yields of the bonds may also be subject to fluctuations during the maturity term with the general market interest rates and the creditworthiness of the bond issuer both playing a role. The duration is an indicator that can be used to measure sensitivity to an interest rate change. Furthermore, it can be used to evaluate the average capital commitment for a bond, i.e. the time an investor has to wait until they can expect to receive all the returns from their bond.
Maturity term and average capital commitment duration
Both indicators are calculated in years. In general, shorter-term bonds involve lower risk compared to bonds with a longer residual term – this must be factored in accordingly. The duration is a good tool to compare two or more bonds which feature the same maturity dates. The shorter the residual term, the easier it is to assess its credit worthiness. It is also generally more advantageous if interest is paid several times and not solely at the end of the maturity since this means that sensitivity to interest changes can be identified. For this purpose, the modified duration and the effective duration apply.
Effective and modified duration
Through the application of the effective duration it is possible to compare bonds which produce about the same yield and feature identical maturity terms. In this case, it refers to bonds which can be terminated prior to the end of their respective maturity terms. For fixed maturities, the term used is called modified duration.
Modified duration refers to the average capital commitment period and the change in present value that occurs as a result of a shift in interest rates following a change to the general market interest rates. Changes in interest are measured in percentage points. The modified duration can thus show by what percentage the market value of a bond has changed, if the change to market interest rates corresponds to one percent.
How investors can use this measurement
Every investor should understand the terms ‘average capital commitment term’ and ‘duration’. The investor can use the average capital commitment term in order to estimate how the value of a bond may develop in the event of changes in interest rates. As a basic principle, it can be assumed that a bond with a longer-term to maturity is more prone to interest rate changes than a bond with a shorter maturity term. However, the achievable yields from bonds with longer terms until maturity are often significantly higher. For this reason, investors should always pay close attention to the duration of any bonds they are intending to purchase.