Question

The text discusses 6 features and the impact of the duration (Pp. 516-518) of a bond that affects the sensitivity of its price. Select and analyze one feature or discuss how duration impacts the sensitivity of a bond.

Consider these questions:

Why is the feature a concern?

What does this mean for investors?

Can investors avoid this feature, why or why not?

Answer 1

Bond duration measures how long it takes(measured in years), for an investor to be repaid the bond’s price by the bond’s total cash flows. Also, interest rates and bond prices move in opposite directions: When interest rates rise, bond prices fall, and vice versa. For a zero coupon bond, duration is equal to its time to maturity. For a vanilla bond, duration will always be less than its time to maturity.

Certain factors affect a bond’s duration :

• Time to maturity. The longer the maturity, the higher the duration, and the greater the interest rate risk. Consider two bonds that each yield 6% and cost Rs.100, but have different maturities. A bond that matures faster – say, in one year – would repay its true cost faster than a bond that matures in 5 years. Consequently, the shorter-maturity bond would have a lower duration and less risk.
• Coupon rate. If we have two bonds that are identical except their coupon rates, the bond with the higher coupon rate will pay back its original costs faster than the bond with a lower yield. The higher the coupon rate, the lower the duration, and the lower the interest rate risk.

To summarize:

Bonds with a long duration have a higher price fluctuation than bonds with a short duration. Also, the higher the coupon, the lower the volatility and the lower the coupon, the higher the volatility

As a result, if you want to invest in a bond to minimize interest rate risk, a good choice would be a bond with high coupon payments and a short term to maturity. If you think interest rates will decline, a good bet would be a bond with low coupon payments and a long term to maturity, since these factors would magnify the bond’s price increase.