Duration and maturity – What are the differences between these concepts and how can they be used by investors?
Bond investors often talk about duration and maturity of bonds when evaluating an individual bond or a portfolio of bonds. Generally speaking, duration and maturity are two key concepts in bond investing that refer to different aspects of a bond’s timeline and sensitivity to interest rate changes. With this in mind, it is worth taking a closer look at these two measures.
durations
Duration is a measure of the sensitivity of a bond portfolio to changes in interest rates. It represents the weighted average time it takes for an investor to receive all cash flows (interest payments and repayment of principal) from the bond. As a result, the duration of a bond is shorter than its maturity. The only exception to this rule is zero-coupon bonds. Since zero-coupon bonds have no interest payments, their duration equals their maturity. This means that duration is a useful measure for assessing the interest rate risk of a bond portfolio, as it estimates how much the bond’s price will fluctuate if interest rates change. A bond with a higher duration is more sensitive to interest rate changes than a bond with a lower duration. For example, if a bond has a maturity of five years, its price will fall by about 5% if interest rates increase by 1% and vice versa. Therefore, duration is a risk measure that can be used to evaluate whether a bond portfolio fits an investor’s risk-bearing capacity. There are different types of duration used by investors. The most common measure is Macaulay duration, which is the weighted average time until cash flows are received, measured in years. Another common measure is modified duration, which directly estimates the bond’s price sensitivity to interest rate changes.
Running time
Maturity is the time remaining until a bond’s principal (face value) is repaid in full to the bondholder. This means, for example, that a 10-year bond issued today has a maturity of 10 years. This means that the maturity tells investors how long they will receive interest and when they will get the principal back. This allows bond investors to plan reinvestments in advance and allows them to compare their bond (portfolio) with other bonds of the same maturity and/or evaluate their positioning on the respective yield curve. The maturity of a bond (portfolio) can be trimmed in one direction or the other by using derivatives. Investors can use the maturity to guide the positioning of their bond portfolio on the yield curve and evaluate the return on their bond (portfolio), as bonds with longer maturities should pay higher interest rates to compensate the investor for the greater uncertainty over a longer period. The latter is obviously not true in times of inverted yield curves.
Summary duration and maturity
When it comes to duration and maturity, it can be concluded that maturity is about the timeline for repayment of principal, while duration is about interest rate sensitivity. In other words, maturity tells you when a bond will run out, while duration tells you how much the bond’s price is likely to move with changes in interest rates. This means that duration and maturity play a key role when an investor is defining the strategic asset allocation for a portfolio, as the implied (interest rate) risk of long-duration bonds – and long-maturity bonds, respectively – may be above the risk an investor can bear.
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