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More About the Risk of Bonds
In a recent blog titled “So You Think Bonds Are Safe?” (Posted Saturday, January 22, 2011, we discussed many of the risks associated with investing in bonds. We won’t repeat the points we made in that article but we wanted to follow up on a concept we introduced to our readers: the concept of a bond’s “duration”.
In the article we discussed at length the how interest rates affect bond prices. If interest rates go up, bond prices come down and vice versa. If you hold a bond to maturity, and the company that issued the bond stays in business, you’ll receive the principle value of the bond and generally won’t lose any money (You could lose money, if you bought the bond for more than the face value of the bond. This could happen, if at the time of your purchase, interest rates are lower than when the bond was issued.)
If you have invested in a bond fund, you will likely be invested in hundreds of bonds and can’t just hold on until all the bonds mature. After all, the fund manager will be buying and selling bonds as he sees fit. Whether you make a profit and how much you make will be affected by a measure called the fund’s “duration”.
Duration is a measure of a bond funds’ sensitivity to interest rates. The shorter the duration the less sensitive the bond funds’ net asset value is to an increase in interest rates. The longer the duration, the more sensitive it would be. Generally, a bond fund with a duration of 5.0 years would drop 5 percent in value for every 1 percent increase in interest rates. Vice versa, the fund will gain 5 percent in value for every 1 percent drop in interest rates.
How one calculates the duration of a bond or bond fund is beyond the scope of our blog. You don’t really need to know how to calculate a bond fund’s duration, however, since Morningstar® provides it for you online. If you go to Morningstar.com, for example and look up JASBX, the Janus Short-Term Bond Fund and then click on the “Portfolio” tab, you will see its “Average Effective Duration,” listed on the right, is 1.8 years. Thus, if interest rates rise 1 percent, you can expect the net asset value of the fund to drop 1.8 percent.
With interest rates likely to increase in the coming years, an investor should be careful about buying bond funds with high durations.
In the article we discussed at length the how interest rates affect bond prices. If interest rates go up, bond prices come down and vice versa. If you hold a bond to maturity, and the company that issued the bond stays in business, you’ll receive the principle value of the bond and generally won’t lose any money (You could lose money, if you bought the bond for more than the face value of the bond. This could happen, if at the time of your purchase, interest rates are lower than when the bond was issued.)
If you have invested in a bond fund, you will likely be invested in hundreds of bonds and can’t just hold on until all the bonds mature. After all, the fund manager will be buying and selling bonds as he sees fit. Whether you make a profit and how much you make will be affected by a measure called the fund’s “duration”.
Duration is a measure of a bond funds’ sensitivity to interest rates. The shorter the duration the less sensitive the bond funds’ net asset value is to an increase in interest rates. The longer the duration, the more sensitive it would be. Generally, a bond fund with a duration of 5.0 years would drop 5 percent in value for every 1 percent increase in interest rates. Vice versa, the fund will gain 5 percent in value for every 1 percent drop in interest rates.
How one calculates the duration of a bond or bond fund is beyond the scope of our blog. You don’t really need to know how to calculate a bond fund’s duration, however, since Morningstar® provides it for you online. If you go to Morningstar.com, for example and look up JASBX, the Janus Short-Term Bond Fund and then click on the “Portfolio” tab, you will see its “Average Effective Duration,” listed on the right, is 1.8 years. Thus, if interest rates rise 1 percent, you can expect the net asset value of the fund to drop 1.8 percent.
With interest rates likely to increase in the coming years, an investor should be careful about buying bond funds with high durations.
posted by David C. Patterson and Erin Preston at
7:01 PM
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