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below-market yield will be stuck

with it for as long as he holds the

bond. Of course, market risk is not

an issue for investors who hold

bonds to maturity because the face

value, not the market value, of the

bond is received at maturity.

Reinvestment risk encompasses

the risk that cash flows received

ADDING from an existing investment, like

semiannual coupon payments, could

DURATION be reinvested at different interest

rates than those paid on the existing

security. When market interest rates

TO THE rise, reinvestment risk works in the

investor’s favor because the cash

TOOLBOX flows received can be reinvested in

higher-yielding securities. When

rates fall, however, reinvestment risk

works against the investor.

by Michelle Clark Neely

An investor faces market risk and

reinvestment risk whenever his

planned holding period for a fixed-

A n increasing num-

ber of Americans are taking

would receive if an asset were sold

today—will change because of chang-

income security is less than its matu-

rity. These risks tend to work in

opposite directions, however: Rising

market interest rates increase market

control of personal invest- ing market interest rates. risk but decrease reinvestment risk,

ment decisions—whether to The degree of interest rate risk while declining interest rates

meet retirement, children’s associated with a given fixed-income decrease market risk but increase

college education or other security (or bond) depends on the size reinvestment risk. In other words,

financial goals. To do this, and timing of the cash flows—interest an initial capital loss (from rising

they’re seeking useful, and principal—from that bond. To market interest rates) may, in time,

understandable tools that see this, consider a zero coupon bond, be more than offset by greater

will guide them in making a bond that pays no interest until returns from reinvested earnings and

profitable choices. One tool maturity.1 Because no interest is vice versa.

that investors in fixed- received until maturity, an investor in

income securities—individ- a zero coupon bond loses out on any

ual bonds or bond mutual opportunity to reinvest potential Duration: The Net Effect

funds—have for assessing earnings at higher market interest

risk versus reward is an eco- rates. In addition, if the investor were So how does an investor know

nomic formula known as forced to sell prior to maturity, he how much interest rate risk—the net

duration. Although it is far could face a substantial loss if current effect of market and reinvestment

from a perfect measure of interest rates on a comparable bond risk—he’s assuming when purchasing

risk, duration is a useful sup- were higher than the interest rate on a bond or shares in a bond mutual

plement to more common, his zero coupon bond. fund? That’s where duration comes

traditionally used measures, However, if the same investor in. Basically, duration measures the

like a bond’s credit rating were to purchase a coupon-paying average life of a fixed-income security

and maturity. bond—like a U.S. Treasury bond— or a portfolio of securities. It is a

instead, his interest rate risk in a ris- more precise measure of the life of a

ing interest rate environment would bond than maturity because it takes

Bond Risk Basics be reduced since interest or coupon into consideration any cash flows

payments received at six-month or that are received prior to maturity. In

Bond investors face several year intervals could be reinvested at general, the sooner cash flows are

types of risk. One is credit or higher interest rates. This would off- received and the larger the amount,

default risk; that is, the risk set some of the loss that might occur the lower the duration, or interest

that the bond issuer will not if the investor needed to sell the rate risk, of the bond.

repay the principal invested. bond prior to maturity. More specifically, duration is cal-

Since very few debt issuers Interest rate risk, then, comprises culated as the weighted average time

default on their obligations, two distinct types of risks, which fre- to maturity of a bond, using the rela-

however, it is less of a worry quently counteract each other: price tive present values of the cash flows

for most investors than or market risk and reinvestment risk. from the bond as weights. The cal-

another major risk, interest Market risk is the risk that an already- culation yields a single number

rate risk. This is the risk that issued bond’s market price will fluc- called Macaulay’s duration that is

the market value of an invest- tuate because of changes in market expressed in units of time, which

ment—the price an investor interest rates. It arises because of the correspond to the receipt of cash

inverse relationship between market flows.2 Macaulay’s duration depends

interest rates and a bond’s price. The on the number of cash flow payment

longer the maturity of the bond, the periods and the interval between

10

Regional Economist

April 1996

them, the size of the cash flows and Another useful feature of duration

the current yield to maturity of the is that, by rearranging the duration

instrument.3 ENDNOTES

equation, it can be used to predict the

1 Zero coupon bonds, like T-bills

To see how duration can be used sensitivity of a bond’s price to very and certain other instruments, are

to judge the riskiness of a fixed- small increases in interest rates. This frequently sold at a discount from

income security, consider two bonds, rearranged calculation is called modi- their face value and do not pay

A and B, which on the surface, at periodic interest or a coupon. The

fied duration.5 The percentage change return, or compounded interest,

least, appear to be very similar. in the price of a bond can be approxi- on these investments is the differ-

Bond A is a coupon bond with a face mated by multiplying the percentage ence between the discounted pur-

chase price and the face value of

value of $1,000 and a maturity of 20 point change in the yield to maturity the instrument.

years; its coupon rate is 8 percent, by negative one and the bond’s modi- 2 The mathematical formula for

and it pays interest annually. Bond fied duration. The modified duration Macaulay’s duration (D) is:

B is a zero coupon U.S. Treasury for Bond A, the 20-year coupon bond

bond that pays principal and interest with a duration of 9.75 years, is 8.86

of $2,600 at maturity. The current years. If market interest rates rise one

yield to maturity on 20-year bonds is percentage point to 11 percent, the

10 percent. Both bonds yield com- price of this bond will decline about

bined principal and interest of 8.9 percent to $911.40. For Bond B, where N = number of cash flows,

$2,600 over 20 years. Which bond, the zero coupon bond, a one percent- t = time to receipt of the cash flow,

then, has the most interest rate risk? age point increase in market interest Ct = cash flow amount in period t,

and r = yield to maturity. The

Although the total cash flows rates would lead to a whopping 18.2 expression Ct/(1+r)t is the present

from bonds A and B are equal at percent decline in price. Of course, if discounted value of the cash flow

maturity, their risk profiles for the interest rates decline one percentage received in each period t. The

sum of all these cash flows is

intervening years are very different. point, Bondholder A would enjoy equal to the market value or price

Bond A has a duration of 9.75 years about a 9 percent capital gain, and of the bond.

while Bond B, the zero coupon Bondholder B would reap an 18 per- 3 The yield to maturity is the

bond, has a duration of 20 years, cent gain. expected rate of return, or interest

rate, on a given debt security held

equal to its maturity. Bond A has This simple relationship between until maturity. Because the yield

the lower duration and is, therefore, duration, interest rates and bond to maturity can be difficult to

the least risky of the two because the prices can help an investor determine calculate, the current market

interest rate on comparable

investor will start receiving cash an optimal investment strategy based securities is usually used in the

flows much sooner than the holder on his expectations about future duration calculation.

of Bond B. If an investor were in a interest rates.6 For example, if an 4 This last property only holds true

position where he would need to sell investor expects interest rates to rise for par and premium bonds. For

deep-discount bonds, duration

a bond—all else equal—his capital in the near future, he would likely increases with maturity to a dis-

loss would be lowest with Bond A. want to keep the duration of his tant point and then declines.

The duration of Bond B is twice as bonds or bond mutual fund short to That’s because bonds with really

long maturities behave like perpe-

large as the duration of Bond A minimize any potential losses, should tuities, bonds that pay coupons

because all of the interest is deferred a sale become necessary.7 Conversely, forever. See Bierwag (1987) or

until maturity. in a falling interest rate environment, Kritzman (1992) for details.

5 The modified duration calculation

an investor may want to lengthen the

is: D m = D/(1 + r) where Dm is

duration of his fixed-income securi- modified duration, D is Macaulay’s

Duration Dynamics ties, for two reasons; first, he may be duration and r is the yield to

able to sell them for a nice gain and maturity or current market inter-

The example above illustrates second, a longer duration positions

est rate.

how differences in the timing of an investor to take advantage of a

6 Duration has its limitations,

mostly because it is based on

cash flows change the duration of rebound in interest rates, which could some unrealistic assumptions.

a bond. Listed below are several lead to profitable reinvestment oppor- For example, duration and modi-

other properties of duration that tunities. An investor may also wish to

fied duration calculations implicit-

ly assume that short-term and

an investor can use either to differ- use duration to partially hedge or long-term interest rates are equal,

entiate the risk characteristics of immunize interest rate risk: Market i.e., the yield curve is flat. See

similar bonds or to anticipate how risk and reinvestment risk almost com-

Bierwag (1987).

changes in bond characteristics pletely offset each other when the

7 The duration of a bond mutual

fund is the weighted average of

alter its duration. duration of a security is equal to the the durations of the individual

investor’s planned holding period. bonds in the fund.

The duration of a bond is always

less than its maturity, except for Duration has been used to measure

and hedge interest rate risk to varying FOR FURTHER READING

a zero coupon bond, whose

degrees by financial institutions and Bierwag, Gerald O. Duration

duration is always equal to Analysis: Managing Interest Rate

its maturity. other institutional investors for Risk (Ballinger Publishing Co.,

decades. With an increasing number 1987).

Duration declines as the coupon of brokers and bond mutual fund Kritzman, Mark. “What

rate rises, holding maturity and managers calculating and keeping an Practitioners Need to Know About

Duration and Convexity,”

yield to maturity constant. eye on duration, individual investors Financial Analysts Journal

would be wise to add it to their invest- (November/December 1992),

Duration declines as the yield to pp. 17-20.

ment toolbox, too.

maturity rises, holding the coupon Saunders, Anthony. Financial

rate and maturity constant. Institutions Management: A Modern

Perspective (Irwin, 1994), Chapter 6.

Duration increases as maturity Michelle Clark Neely is an economist at the Williams, Gordon. “Deciphering

increases, holding the coupon rate Federal Reserve Bank of St. Louis. Thomas A. Duration,” Financial World

(October 12, 1993), pp. 80-82.

and yield to maturity constant.4 Pollmann provided research assistance.

11

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