Bond Portfolio Duration and the Flaw of Averages
While a fund’s duration is useful, investors need to understand where the bonds sit on the yield curve to understand its impact.
Interest-rate sensitivity, credit risk, and exposure to the yield curve are three of the biggest factors that have an impact on a bond's price. As a measure of interest-rate sensitivity, duration tells investors how sensitive a bond is to changes in interest rates. Theoretically, the longer a bond's duration, the more sensitive it is to changes in interest rates, and vice versa. In terms of credit risk, higher-quality bonds are generally more sensitive to changes in interest rates than lower-quality bonds.
The yield curve, in its simplest form, depicts yields at a point in time for U.S. Treasuries with differing maturities. In normal markets, as the time to maturity increases so would a bond's yield. This is intuitive because interest-rate risk tends to increase with maturity, and investors demand compensation for this risk. Investors' expectations of future short-term rates also influence the shape of the yield curve. If investors believe short-term rates will fall in the near term, the yield curve may become flat or even inverted--where long-term yields are lower than short-term yields.
Thomas Boccellari does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.