How Do Interest Rates Affect Your Bonds?

After steadily increasing rates seven times over 2017 and 2018, the Fed eased off the gas this year, cutting rates twice. The federal-funds rate, the interest rate at which banks lend money to each other overnight, is now targeted between 1.75% and 2.00%. When the Fed raises or lowers rates, it affects bonds' prices to differing degrees.

Duration measures the degree of this impact. Let’s break down why interest rates affect bonds in the first place, what duration is, and why it matters.

Why are bonds sensitive to interest rates? Before we explain duration, let's back up and explain why changing interest rates affect a bond's price.

Bonds are competitive with each other. When the Fed raises rates, new hotshot bonds stroll in paying a higher interest rate, so investors who buy them receive higher payments. The older bonds need to do something to stay competitive, or else no one will buy them. Think about it--if one bond offers you a higher annual payment, all else equal, why would you choose another?

Because older bonds’ interest rates are already locked in, the only way to increase their yield is to lower their purchase price. In other words, investors buy the bond at a discount to their par value--say $800 for a bond with a $1,000 par value (we'll define par value below). This discount creates an equivalency where investors are equally happy owning older and newer bonds when factoring in their prices and payments.

The opposite applies when the Fed lowers rates. Older bonds are now more attractive, so their purchase prices often rise while still remaining competitive with new bonds.

What is duration? Duration measures a bond's sensitivity to interest-rate changes. I think it's best understood by first considering its non-finance definition: the time or length something exists or lasts.

In finance, duration represents the time over which a bond investor gets paid back. A higher duration means that a bond issuer repays its debt over a longer time period. Duration incorporates many factors:

• Par value = The bond's value, which you'll receive back, often at the end of the loan.
• Coupon payments = An extra income source where a percentage of the bond's par is paid out (usually semiannually).
• Maturity = The length of time between when a bond is purchased and when it's fully repaid.

In simple terms, a bond's duration will estimate how much its price will be affected by interest-rate changes. The longer a fund's average effective duration, the more sensitive it is to shifts in interest rates. Here’s very simplified version of how it works: If rates move up by 1 percentage point, the price of a bond with a duration of 5.0 years will move down by 5%, while a bond with a duration of 10.0 years will move down by about 10%. (See the actual formulas below.)

The visual learners among us might understand duration better as the “fulcrum” on a see-saw. If you line up all the bond coupon payments, starting with the first coupon payments in year one at the left and the final lump-sum repayment at maturity, the bond’s duration is the point at which the investor has recouped the purchase price of the bond.

How does duration affect interest-rate sensitivity? Lower-duration bonds have lower interest-rate risk. That's because there is more certainty about where interest rates will be over a shorter time period than a longer one. There's more time for interest rates to fluctuate over longer periods of time, and therefore more opportunities for price volatility over longer time periods.

How do I use duration? If you think the Fed will continue lowering interest rates, consider bonds or bond funds with higher (or longer) duration. Higher-duration bonds are more affected by interest-rate changes, so in a falling-rate environment, longer-duration bonds' prices would rise more than shorter-duration bonds'.

If you think the Fed will raise interest rates, on the other hand, you’ll want exposure lower-duration bonds. Because bonds' prices fall when interest rates rise, keeping your duration exposure low (or short) will minimize the losses.

However, if you're investing for longer than a few years, you don't really need to worry about interest rates affecting your bonds. You have time on your side, which will help you ride out price swings from changing rates. Or, better yet, leave it to the professionals: consider a low-cost active core bond fund, where a portfolio manager will actively shift the portfolio's duration based on her forecast of interest-rate changes. (And if you're not sure how to invest in bonds, here's a helpful guide).

What are the formal calculations for duration? There are two main duration definitions, but their calculations are in the weeds. Let's focus on what they mean broadly and how to interpret them.

Macaulay Duration: Answers "Including all of a bond's payments, when is the average time an investor receives a dollar?"

If a bond pays $100 exactly one, two, and three years from now, its Macaulay Duration is two years. Or, the average dollar is paid out in year two.

Most bonds have a lumpier duration, like 2.66, driven by a large, final payment.

The bond might not pay investors anything in 2.66 years. Remember, that’s not what Macaulay Duration measures. It averages the time each cash flow gets paid, weighted proportionally to the payments’ amounts.

Modified Duration modifies Macaulay Duration to answer, "If interest rates change 1%, how many percentage points will this bond's price increase or decrease by?"

A 2.5 modified duration means that interest rates shifting from 6% to 7% will reduce the bond’s price by $2.50 if it has a $100 par value.