10 May 2024
If you’re considering a bond, one of the first questions is, do you want one with a short or long duration. A short duration means the time to maturity is generally less than 5 years, which can mean that there’s less time to wait before re-investing, or taking the funds out. This can also mean a greater degree of certainty over the expected returns.
When you buy a bond, you know what the fixed interest rate will be paid on it.
The returns of a bond are composed of coupon income and price changes. A key measure of bond markets is the bond ‘yield’, which is the amount an investor will get from it. Yields from bonds are inversely related to bond prices. When yields rise, bond prices fall assuming all factors unchanged. Factors driving yields include changes in credit ratings and interest rates.
An illustrative example
However, what happens if the interest rate falls?
In the above example, if the interest rates were cut to 2%, these bonds would look more attractive, as they are paying above market rate. If they are more attractive to the markets, the price of the bond would rise.
So, a cut in interest rates is likely to increase the price of bonds. A rise in interest rates is likely to reduce the price of bonds.
A yield curve is a line that plots yields (that is, the annual rate of return until maturity) of bonds with equal credit ratings but different maturity dates. There are generally three types of yield curve;
1. Upward Sloping
When an economy is growing, we should see an upward-sloping yield curve. Bonds with a longer-term maturity date typically offer higher yields to compensate for the additional potential volatility, for example with regards to interest rates.
2. Downward (inverted) sloping
A downward or inverted yield curve likely indicates an economic downturn, as investors expect lower interest rates to be used to stimulate economic growth.
3. Flat
A transition between these two scenarios could result in a flat yield curve.
The interest rates set by central banks are a key driver of the cost of borrowing, for governments and businesses. When inflation falls, central banks tend to decrease interest rates to stimulate economic activity and encourage increased spending. In such an environment, bond yields tend to decrease.
The situation will reverse in a higher inflation environment where central banks can raise interest rates to slow down the economy and reduce inflation.
Duration, expressed in the unit of years, measures the sensitivity of bond prices to interest rate movements. The longer the duration, the more sensitive the prices to interest rate changes. Shorter-term bonds (typically up to 5 years) are generally more resilient to interest rate fluctuations than longer-term bonds.
If interest rates rise by 1%, bond prices will normally drop by around 2% and 4% for a bond with a 2-year and 4-year duration respectively. Conversely, if interest rates fall by 1%, a bond with a 2-year duration could experience a gain in value of around 2%, while the price of a bond with a duration of 4 years could increase by around 4%. This is based on previous experience in the markets and analyst views of future changes.
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