In the previous two blogs, we talked about how risk can throw off your expected returns and how standard deviation can be used to measure risk.
In this blog we will talk about measuring the riskiness of bonds.
The natural question is that how can bonds be risky when they promise a fixed interest periodically and the repayment of the principal upon the maturity date of the bond? Apart from the possibility that the bond issuer may default on its payments, bonds take on risk because their value before maturity date may go up or down.
It is like a see-saw. When interest rates move up, bond prices move down. When interest rates move down, bond prices move up. So if you bought a bond with the intention of possibly selling it before maturity date, you took on market risk.
As mentioned, bonds react to movements in interest rates. And financial experts have come up with a measure to determine how much a bond’s value will move with changes in interest rates. In particular, this measure is called modified duration.
The formula for modified duration is already built into MS Excel so we will not bother with it. Suffice it to say that modified duration gives the approximate percentage change in a bond’s price per +/-100 basis point change in interest rates, assuming that the bond’s expected cash flows remain fixed (as some bonds have variable cash flow).
So if a bond has a modified duration of say 5 (i.e. the technical convention is in years), it means that this bond’s value will go down by 5% for a 100 basis point rise in interest rates (i.e. 1% x 5). And for a fall in interest rates of 100 basis points, this bond’s value will go up by 5% (i.e. 1% x 5). Remember that bond prices move in the opposite direction of interest rates.
Modified duration can also be used for a portfolio of bonds like a bond fund. And the same rules apply: the higher the portfolio’s modified duration, the wider will be the band within which the portfolio’s value will move with the change in interest rates.
At the end of the day, the higher or shall we say the longer the modified duration, the wider the band of price movement and therefore the riskier the bond or bond portfolio is. So next time you are buying a bond or a bond fund, find out what the modified duration is to see if the risk level of that bond is aligned with yours.
The only way you can get rid of the band of bond price movement is if you buy bonds with the intention of holding them up to maturity. Just make sure you are already contented with the interest you will be receiving.
Article Originally written by: Efren L. Cruz, RFP at www.savingtips.com.ph
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