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Duration based approach to Investments?

Introduction:

Duration Based Approach in investment depends on the investment goals and time frames, the amount of risks that can be taken and the income and tax structure. Investments on the basis of duration could be classified as: Short-Term, Medium Term or Long Term .

  • Short Term Investment: Investments made by an individual or organisation that will expire within one year. Commonly, these accounts contain stocks and bonds that are considered highly liquid assets. Example- Investing money for going in a vacation within a year, investing in company’s yearly inventories.
  • Medium term: An intermediate duration asset holding period or investment horizon. The exact time period to be considered as medium term depends on the investor’s personal choices, as well as on the asset class under consideration. Bonds that have a maturity period of between 5 to 10 years are considered to be intermediate -term bonds In the fixed-income market. Example – Investing money for buying a house in 5 years, investing in machineries which will last for 5 years.
  • Long Term Investments: The account on the asset side of the balance sheet of any company which represents the investments that the company intends to hold for more than ten year. It includes real estate, stocks, bonds and cash. Example – Investing money in retirement scheme benefits, investing in long term assets of factories.

Measurement of duration:

  • Effective duration can be defined as the percentage change in security’s price that results from a change in yield of 100 basis points. e.g. – The price of a bond with an effective duration of 2 years will rise 2% for every 1% decrease in the yield. Similarly the price of a bond with duration of 5 years will rise 5% for a 1% decrease in the yield. As interest rates and bond yields are directly correlated, the longer the bond’s duration the more sensitive is its price to changes in interest rates.
  • Curve Duration- Estimates portfolio bond’s price sensitivity to changes in the shape of the yield curve that is whether it is steepening or flattening. The curve duration of a portfolio is considered positive if it is having greater exposure to the 2 to 10 year part of the curve. As the yield curve steepens a portfolio with positive curve duration will perform well and vice-versa. A portfolio having negative curve duration has more exposure to the 10 to 30 year part of the curve. It will perform poorly while the yield curve steepens and vice-versa.
  • Spread Duration-Estimates the price sensitivity of a particular asset class to a movement of 100 basis points in its spread relative to Treasuries. e.g. – Corporate spread duration considers the widening or narrowing of the spread over LIBOR in floating-rate notes. The corparte spread duration for fixed-rate is exact as standard duration. Spread duration of mortgage considers the widening or narrowing of the option adjusted spread which incorporates the prepayment risk of mortgage-backed securities.
  • Total Curve Duration-Estimates the price sensitivity of a portfolio to changes in the shape of the yield curve relative to its benchmark’s sensitivity to those same changes.

The Importance and uses of duration based approach

  • Duration is a useful concept as it provides a good approximation, notably when interest rate changes are little, for the sensitivity of market value of security to a change in its interest rate
  • If the outlook on bonds is bullish interest rate falls and duration extends. Where as if the outlook is bearish interest rate rises and duration reduces. Besides, fund managers use duration to construct the most appropriate portfolio for any investor.
  • Under normal market conditions low duration strategies (average portfolio duration of 1 to 3 years) should be less volatile than longer duration strategies and are frequently used as an alternative to traditional cash instruments such as money market funds. When interest rate is low and an investor is willing to accept additional risk in pursuit of greater return, a low duration portfolio has the potential to be a higher yielding choice to money market funds.
  • Moderate duration strategies (average portfolio duration of 2 to 5 years) is appropriate for investors in pursuit of the potential higher returns than money market or short-term investments by taking additional risks.
  • Under normal market conditions, long duration strategies (average portfolio duration of 6 to 25 years) offer comparatively stable substitute to equities. Moreover, they are appropriate for an investor looking for a compact match between the portfolio duration of and liability duration. Longer duration strategies tend to benefit from uncertainty in the financial markets that might cause a flight to quality into Treasuries or equity market volatility.

Equal duration is not the indicator of equal return:

Even though duration is a powerful tool in constructing portfolios, portfolios with the identical duration do not necessarily provide equal returns. e.g.- a hypothetical portfolio with 10 year Treasuries returned 16.8% from November 2011 to November 2012. During the same period, a portfolio of 2 year and 30 year Treasuries with the identical duration as the portfolio of 10 year Treasuries produced a return of 13.2% (a contrast of 360 basis points). This can be explained by the phenomena of yields on Treasuries of different maturities which hardly move in unison.
 

Duration based investment strategies:
In a bond investment strategy it is important to remember the necessity of diversification. Generally, it’s a bad idea to put all your assets and all your risk in a single asset class. It is prudent to diversify the risks within the bond investments by creating a portfolio of several bonds of different variety. By choosing bonds from different issuers the investor is protected from the possibility that any one issuer might be unable to meet its obligations. Bonds of different types like government, agency, corporate, municipal, mortgage-backed securities, etc. protect from the possibility of losses in any particular market sector. Managing interest rate risk is also made possible by selecting bonds of different types. Duration based approach to investments can involve different strategies.
If the primary goal of the investor is preserving the principal and earning an interest on it then it is better to adopt a “Buy and Hold Strategy” i.e invest in the bond and keep it till maturity while earning the interest in that duration. The interest payment is generally made two times in a year and at maturity the investor receives the face value of the bond. The buy and hold strategy reduces the impact of interest rates on the bond’s price or its market value. Holding the bond also implies that the principal cannot be utilised to reap the benefits of the interest rates currently prevailing in the market. If the bond chosen is callable it involves the risk of the principal being returned to the investor before maturity. Usually bonds are redeemed or called back early by the issuer if the interest rates are declining. This would also imply that the investor would be forced to invest the redeemed principal at the lower rates prevailing in the market. The buy and hold strategy works out best as a long term investment plan.
When investing in the long term plan it is necessary to consider the coupon interest rate of the bond. By multiplying this rate with the face value of the bond the investor can determine the total amount of annual payments of interest. It is also advisable to know the yield-to-maturity / yield-to-call. The higher the yields, higher the risks involved. Also important is to note the credit rating of the bond and the credit quality of the bond issuer.
There might be circumstances where the investor even after adopting the buy and hold strategy is forced to sell the bonds before their maturity period.
Firstly, the investor could need the principal amount invested. Depending on the interest rates the investor may get either more or less than the original investment. If the interest rates have increased over time then the bond’s value would be lesser than its initial value. On the other hand if the interest rates have declined over time, the present value of the bond would be more than its initial value.
Secondly, the investor might want to capitalize a gain. If the interest rates have fallen and the bond’s value has increased then they might want to sell the bond before its maturity.
Thirdly, the investor might sell the bond prematurely for tax benefits. The investor may adopt the strategy of selling the investment at a loss to offset the tax impact of gains in investments. This swapping of bonds can help in achieving the tax objective without affecting the portfolio profile.
Investors adopting the buy and hold strategy can manage the risks due to interest rate fluctuations by creating a “Laddered” portfolio of bonds i.e. invest in bonds having different maturity periods like one, five and ten years. A laddered portfolio ensures that the principal is redeemed at definite intervals. The investor can reinvest the principal to capitalize on the prevailing interest rates at these definite intervals.
The investor may choose to save/invest to meet certain future goals like a child’s college education or a retirement home. Since bonds have a pre-defined maturity period they can help in providing the money when needed in the future. Zero coupon bonds are one such investment. They are sold at a high discount from the amount of face value which is redeemed at maturity. Interest is associated with the bond during its lifetime. The interest is factored into the difference between the original value of the bond and its current face value on maturity of the bond period.
Thus the investor can build a laddered portfolio of zero coupon bonds each maturing at a time as required by the investor to meet his/her future goals. Zero coupon bonds are more vulnerable to changes in the interest rates. Hence there is a risk involved if the investor needs to divest them before their maturity period. It’s also advisable to invest in zero coupon bond in a tax-deferred savings account. This is because even though the cumulative interest is received only on maturity they might be taxable.
Another strategy that can be adopted is called the “Bullet Strategy”. If today the investor wants to save for 12 years from now he/she can buy a 12 year bond today or 10 year bond after two years or a five year bond after seven years from now. By arranging/ stacking the investments in this order the investor can benefit from different cycles of interest rates.
One more strategy is called the “Barbell Strategy”. Here the investor buys short term and long term bonds but not intermediate bonds.

Duration Gap Analysis:

A method for measuring interest rate risk, termed as duration gap analysis, tests the reactivity of the market value of the net worth of any financial institution to variations in interest rates. Duration analysis is established on Macaulay’s duration concept, which calculates the average lifetime of stream of payments of a security. The following formula can be used for measuring duration gaps:
 
% ∆P ≈ – DUR×∆i/(1+i)
Where, percent change in market value of the security
DUR =duration
i =interest rate
 
After determining the duration of all assets and liabilities on bank’s balance sheet, the bank manager can use this formula to measure the market value of each asset and liability changes when there is a change in interest rate and can calculate its effect on net worth. There is an alternative way, which uses the additive property of duration. The duration of a portfolio of securities is the weighted average of the durations of the individual securities, with the weights showing the proportion of the portfolio invested in each.
 

Conclusion:

Duration, the most commonly used measure of bond risk quantifies the effect of changes in interest rates on the price of a bond or bond portfolio. With Prolonged duration the bond or portfolio is more sensitive to changes in interest rates.

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