Question

How's a bond's duration determined? How can a bond's duration be useful in managing a bond portfolio?

What are the various features of a typical corporate bond?

Answer 1

Duration of Bond

Duration of bond is the weighted average time period up to which our initial investment is received.

How to calculate duration of bond?

Where

Kd= Cost of debt

n= number of years

Int= interest received

Bo= Present value of bond

Let’s understand it by an example

There is an another concept which is called modified duration. This is basically a sensitive analysis and it will say how much bond price will change when yield to maturity is changed. Its formula is

Modified Duration= Duration/(1+Kd)

So in our example modified duration = 3.504/(1+0.08) = 3.24

That means if 1% Kd will change then my price will change by 3.24%.

Duration is directly related to price volatility. It is also helpful in taking investment related decisions. By using duration of bond we can offer an investor right advise as per his needs. We also know about the interest rate risks from duration which is also play a significant role in investment decisions.

Features of corporate bond.

Guaranteed payment = By checking the face value we can be assured that this much amount will be returned to us at maturity. So this is an important feature because it shows that when and how much payment will be made to investors.

Time period = Every bond comes with a time period. Some may be matured at short period like 1 month, 3 months, 1 year. Some may bear long term horizon like 10 years, 20 years and 30 years.

Callable bonds = There are some bonds which come with this feature. In this type of bond company can purchase the bond from investors before its maturity. This normally happens when interest rates are lower. For an example if interest rate is 2% and company is paying bondholders 3% then company will call the bonds to ignore extra interest payments.

Security = Company often offers bond holders some collateral security as a guarantee. For an example company attach fixed assets as a collateral security for bond holders. That means if company default payments then whatever payment receive from fixed asset, it will go to bond holders.