Financial Blog

In the first installment of our ‘Did you Know’ series, Understanding Coupon Rates and Yield to Maturity of Bonds, we illustrated the relationship between these two commonly used types of return: Coupon Rate, which is the rate at which the bond is priced upon its primary issuance; and the Yield to Maturity (YTM), the rate at which the bond is priced in the secondary market. As the bond is actively traded in the secondary market, we highlighted that the YTM of the bond change is based on prevailing interest. This time, we’ll take things a bit deeper and talk about Bond Duration.

Bond Duration

Duration is a measure of the sensitivity of the bond to changes in the interest rates. You can use this as a basis to estimate how much your bond’s value will change as interest rates move up or down. To be specific, Modified Duration is the one commonly used. The measure approximates the change in the price of a bond given a 1% change in interest rates. 

Let’s look at two (2) actively traded government bonds below as an example.

As you can see in the example above, with RTB 05-13, given that Modified Duration is 3.97, a 1% change in yield will result in an approximate 3.97% change in price. Conversely, the price of RTB 03-11 will change by 2.67%. Remember that this is an approximate and not the exact change in value. This means that if you have Php 1,000,000 each invested in both bonds and interest rates subsequently move up by 1%, you will approximately lose Php 39,700 (3.97% X 1,000,000) in RTB 05-13 and Php 26,700 (2.67% X 1,000,000) in RTB 03-11.

What does this mean? Should I always go for the less risky bond?

You’ve probably noticed that the longer the maturity of the bond, the higher the Duration, and therefore, higher risk. So you might be thinking to yourself, should you always go for the less risky bond? Not necessarily.

The direction of interest rates goes both ways. Remember our previous lesson? Yield has an inverse relationship with price. If interest rates go up, the bond value goes down. Conversely, if interest rates go down, the bond value goes up. Following the example given above, if you have Php 1,000,000 each invested in both bonds, and interest rates subsequently move down by 1%, you will approximately gain Php 39,700 (3.97% x 1,000,000) in RTB 05-13 and Php 26,700 (2.67% x 1,000,000) in RTB 03-11.

Key takeaway

What we can pick up from this lesson is that aside from the measure of risk, the Duration can be used as a strategy to maximize gains – buy long term bonds if your view is that interest rates will go down while buying short Duration bonds if your view is that interest rates will go up. 

In the end, if you want to go for a steady value, go for a Short Duration. If you can stomach drastic changes in value, go for a longer Duration. 

To better appreciate this lesson, you may see for yourself the relationship between yields, bond price, and Duration in our Bond Duration Calculator.