How risky are your bonds?

When you buy a bond – an IOU from a company or government, in effect – one obvious risk is that the borrower will default on its obligations (“credit risk”). That’s something you can manage by looking at the creditworthiness of the borrower itself. However, there’s another, big-picture risk you also have to consider – interest rates. If rates rise, bond prices will tend to fall as yields rise (prices and yields move inversely to one another) in line with the returns available elsewhere. Similarly, falling interest rates will boost bond prices. But how do you measure the risk that rates will change?

That’s where “duration” comes in. There are various different types of duration, but put simply, a bond’s duration measures how sensitive it is to a change in interest rates. Specifically, it measures the point at which the bond will have paid out half of the present value of all its future cash flows. That might sound complicated, but you don’t have to do the sums – you can get the figure on plenty of websites.

Duration is derived from both “coupon” payments (the interest paid by the bond) and the “maturity” date – that is, the date at which the bond repays its face value to the holder. For a zero-coupon bond (where no interest payments are made), the bond’s duration and maturity will be the same. For bonds that pay out a coupon, the duration will always be shorter than the maturity.

The higher the coupon, the lower the duration and vice versa. The same goes for maturity – all else being equal, a bond with several years to run before maturity will have a greater duration than one that is about to mature. This all makes intuitive sense – the higher the coupon, the more rapidly you make your money back; and the longer you have to wait until maturity, the greater the risk of interest rates moving against you.

To determine how much a rate change might affect a bond’s value, you simply multiply the duration by the size of the change in rates, then take the negative of the answer. So raising rates by 2% would reduce the value of a bond with a duration of five by roughly 10%. However, if the duration were only 2.5, the same rate rise would cut the value of the bond by only 5%. Duration is just one factor affecting prices, so this isn’t a hard-and-fast rule, but it’s a useful rule of thumb.

Should I buy individual bonds or invest via a fund?

Duration and interest-rate risk also play into the debate over whether to invest in bonds directly, or via a fund or exchange-traded fund (ETF). One popular (but mistaken) argument is that buying individual bonds rather than bond funds reduces the impact of duration on returns.

According to this view, duration only matters to bond funds, which constantly trade bonds on the secondary market, and so aim to profit from changes in price. By contrast, the private investor doesn’t need to bother about duration, if he or she intends to hold the bond to maturity.

Here’s why that view isn’t quite right. It’s true that an investor who invests in bonds with high duration, such as long-dated zero coupon gilts, may not make a capital loss on their investment, even if rates rise (as long as they hold it to maturity). But those who hold their bonds forgo the opportunity to reinvest at a higher interest rate.

In theory, both the investor who buys and holds and the one who sells and reinvests should end up with the same return. The only benefit from holding bonds to maturity is that it reduces transactions costs.

However, bond funds and ETFs don’t have to worry as much about these costs, because they benefit from large economies of scale. In more obscure markets, these can be dramatic. Northern Trust point out that in the American municipal bond market, for example, trades worth $100,000 or less incur costs of 1.2%; those worth $1m incur 0.5% in charges; and those worth $5m, just 0.1%.

This also allows bond funds to build diversified portfolios filled with bonds of different types and durations, reducing risk, at a relatively low cost.

While the average investor can now buy bonds directly via a broker, it is still not as easy as it is with shares and it’s a lot more expensive. Bonds also tend to be much less liquid than shares, so you could find yourself struggling to get an acceptable price if you need to sell in a hurry. Overall, unless you have expertise in this area, or are particularly confident, you would generally be better off sticking to bond funds and ETFs, particularly if you are investing in bonds that carry significant credit risk, such as corporate bonds.