As interest rates rise, bond values fall and vice versa. Think if it this way, if I purchase a bond for
$100 that pays 5% and interest rates rise to 6%, why would someone pay me $100 when
they can earn an extra 1% a year for the same price?
Typically, the longer dated the bond the greater the price
sensitivity of the bond. This can be
expressed in the bond portfolio’s duration. A bond portfolio with a higher duration will
have larger prices swings as interest rates move (in either direction) than a bond portfolio with a lower duration.
The nice thing about duration is that it gives you an easy
way to calculate how your bond portfolio will change in value, given a change
in interest rates.
For example, if your bond portfolio’s duration is 5 then for
every 1% RISE in interest rates, the value of your bond portfolio will DECREASE
by 5%. Similarly, in the case of a 1%
FALL in interest rates, the value of your
bond portfolio will INCREASE 5%.
Note, this is just the value and does not include interest payments you
receive throughout the year.
Given how low interest rates are now, in my next post I will
detail what will happen if rates rise.
