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10.01.03
One of the simplest measures of risk in bond investing is duration. This is essentially a measure of price in relation to an interest rate move. In spite of what Mr. Greenspan might suggest, a sign that inflation has regained firm footing will send those historically low rates higher. When that happens, those folks who hold certificates of deposits jump for joy at the increase in their interest income. The price of that bond you are holding, however will also be affected.
In determining the sensitivity of a bond to interest rates, bond fund portfolio managers use a McCauley measure. As you will notice on the chart above, this is calculated using the coupon returns over the life of the bond. In the case of this hypothetical bond paying 7.5%, the value of each coupon is calculated. Dividing the total of the coupons paid by 100 determines the duration.
Over the last couple of months, bond prices have fallen while yields have soared. Once the duration is determined, and this duration measure is best used on bonds that have a limited chance of default. Simply put, default means that the lender will most likely pay. That risk is usually built into the interest.
The easiest way to look at duration is to find a comparable index. Comparing your fund this way is rather simple. Once you determine the index, you subtract the bond's duration from the yield. This will give you the potential return when interest rates move up or down by a full percentage point. A one point increase in rates can deliver a zero return for the year.
Which brings the Treasury note back into better focus. Three things can effect the price of these types of bonds: supply and demand, monetary policy, and inflation. With the federal deficit running towards the trillion and half dollar mark, supply of bonds is not an issue. Demand, however is another matter. Monetary policy has been closely regarded of late because of those low rates and relatively free wheeling printing presses over at the federal reserve. We are printing money at a record pace and this increased liquidity (availability of funds to borrow) is showing no signs of letting up. Inflation is right around the corner and once that corner is turned, monetary policy will once again come into sharper focus. All of these factors have an effect on that coupon payment and the duration of the investment.
One of the simplest was to avoid any risk because of changes in duration is to invest in a balanced mutual fund. Unfortunately, the McCauley measure does not work as well on bonds that have a chance, even a slim one, of not repaying the loan.
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